F8AA (IntRQB-As d08

REVISION QUESTION BANK AUDIT AND ASSURANCE (Int) (F8)
Answer 1 AUDITORS AND AUDITING STANDARDS
(a) Development, role, and authority of ISAs
ISAs set out the basic principles and essential procedures that auditors should
follow in the conduct of an audit of financial statements. Auditing Standards are in
bold type. The grey type found in ISAs provides guidance on the application of
ISAs.
Each Standard contains objectives and requirements (shall) with related guidance
(introductory, explanatory, application, definitions and other material, including
appendices). The entire text of a Standard must be understood in order to apply the
requirements of that Standard.
A current project is underway to redraft all ISAs not to revise but to rewrite in
plainer language and an improved structure. The differentiation between bold and
plain text has been removed. The structure of the redrafted standard will show the
objective and requirements of the standard and will be supported by application and
other explanatory material all of which should be considered as an integral part of
the standard.
International Standards on Auditing are set by the International Auditing and

Assurance Standards Board (IAASB) of the International Federation of Accountants
(IFAC). The IAASB is made up of representatives (in practice, commerce, research
and academic) of the profession who are members of IFAC.
ISAs and other documents issued by the IAASB are developed using a process of
exposure and consultation in order to obtain consensus and wide-spread acceptance
of standards. Consultation is with interested parties outside the profession, as well
as within the profession itself.
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AUDIT AND ASSURANCE (Int) (F8) REVISION QUESTION BANK
Project is proposed and input sought
If approved, project assigned to a Task Force
Research carried out and Exposure Draft prepared
ED placed on IFAC website and widely distributed for comment

to member bodies, interested parties and
general public
Comments received are considered, ED revised and re-issued if

substantive changes made
Revised ED approved and issued as a Standard
Projects are identified by the members of the IAASB, the Consultancy Advisory
Group, the Forum of Firms, national auditing standard setting bodies and IFAC
members.
The Consultancy Advisory Group gives representatives of the business community

and international organisations the opportunity to contribute to the development of
international auditing guidance. Members of the Group represent organisations that
have an interest in international auditing.
The Task Force carries out the basic research and development of an Exposure
Draft (ED). This may be done as a joint project with a national auditing standard
setting body.
ISAs apply to all audits of financial statements that are expressed in true and fair,
fair presentation, or similar terms. Each of the objectives within a Standard must
be considered within the context of the overall objective of the audit as a whole. If
an objective cannot be achieved, the auditor must use their judgement to evaluate
the impact on their ability to achieve the overall audit objective.
By their very nature, ISAs require auditors to use their professional judgement when
applying them.
In exceptional circumstances, a professional accountant may judge it necessary to

depart from a basic principle or essential procedure of a Standard (and Practice
Statement) to achieve more effectively the objective of the engagement. When such
a situation arises, the professional accountant should be prepared to justify the
departure.
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(b) The role of the ACCA in the regulation of auditors
Auditors are regulated differently in different countries. In some countries

governments regulate auditors directly, or through government organisations (eg the
Public Accounting Oversight Board in the USA established by the Sarbannes-Oxley
Act). In other countries the profession is self-regulating. In most cases, there is
some combination of self-regulation and government regulation.
In the UK, the monitoring of the quality of the audit function carried out by listed
company auditors is conducted by the Professional Oversight Board for
Accountancy (POBA) of the Financial Reporting Council (FRC).
The FRC is the UKs independent regulator for corporate reporting and governance
and is responsible for:
setting, monitoring and enforcing accounting and auditing standards

statutory oversight and regulation of auditors
overseeing the regulatory activities of the professional accountancy bodies
promoting high standards of corporate governance
operating an independent investigation and discipline scheme for public
interest (eg listed) cases
Inspection of auditors under the monitoring of the POBA is carried out by the Audit
Inspection Unit (AIU). Such inspection incorporates a very thorough quality
control review including reviews of audit working papers and audit procedures.
The regulation and inspection of auditors for non-listed companies is carried out
directly by the professional bodies, eg the ACCA.
Professional bodies such as the ACCA, seek to uphold professional standards, to

investigate complaints against auditors, and to assist auditors in the performance of
their duties. They have both investigative powers and sanctions against auditors
who do not comply with professional standards. These include fines, exclusion from
membership, and the withdrawal of the licence to audit (audit registration).
Members of the ACCA are bound by its Rules of Professional Conduct.
The ACCA encourages high professional standards by setting academic

requirements for those wishing to study for the examinations, by setting the
examinations and by requiring additional experience of those who wish to practice
as auditors. This includes passing both Auditing papers (F8 and P7) in the ACCA
examinations.
In addition, all members of the IFAC (this includes the ACCA) are required to
continue their development throughout their careers (CPD).
(c) How ISAs and national standards influence each other
In a global market-place it is increasingly important that Auditing Standards are

harmonised across the world, particularly for multinational companies. It is also
important that Auditing Standards are applied consistently. Over the last ten years,
standard setters in those countries where the profession is mature have sought to
harmonise their own standards with International Standards, and to influence
International Standards.
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In many countries, all new national Auditing Standards contain a statement to the
effect that compliance with the national standard will ensure compliance with the
relevant International Standard in all material respects, if that is the case, or it will
explain the difference(s).
The requirements of the Standards do not override local regulations governing audit
and assurance in a particular country. If local regulations have been followed and
ISAs (and Practice Statements) that are applicable to the engagement have not been
applied in their entirety, then compliance with ISAs cannot be stated as fact.
It is not always possible for local Auditing Standards to be the same as International
Standards because of local legal requirements. Nevertheless, a number of countries
have accepted International Standards in their entirety, or have accepted them
subject to some minor local variations. International Standards are thus extremely
useful for countries where the profession is not strong and where government does
not seek to detail Auditing Standards, and where there are few resources to develop
local standards.
Standard setters in countries where the profession is mature make a significant

contribution to the development of ISAs by providing representatives to sit on IFAC
Committees and working parties and by providing the resource to help draft
standards. National standard setters comment on consultation papers and exposure
drafts issued by the IAPC and help summarise responses on certain projects.
ISAs only have force internationally if they have the support of those countries who
lead the profession internationally. It is therefore essential for both national standard
setters and international standard setters to take account of each others work.
Answer 2 JUMPER & CO
Memo
From: A Manager, Tela & Co

To: Jumper & Co
Subject: Corporate Governance in the SGCC Company
Date: dd/mm/yyyy
As requested, I write to explain where your client SGCC does not appear to be following appropriate
corporate governance codes and to recommend changes to ensure that the principles of good corporate
governance are being followed.
Chief Executive Officer (CEO) and Chairman
Mr Sheppard is both CEO and chairman of SGCC. Corporate governance indicates that the person
responsible for running the company (the CEO) and the person responsible for controlling the board
(the chairman) should be different people. This is to ensure that no one individual has unrestricted
powers of decision.
I recommend that Mr Sheppard is either the CEO or the chairman and that a second individual is
appointed to the other post to ensure that Mr Sheppard does not have too much power in SGCC.
Composition of board
The current board ratio of executive to non-executive directors is 5:2. This means that the executive
directors can dominate the board proceedings. Corporate governance codes suggest that there should be
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a balance of executive and non-executive directors so this cannot happen. A minimum of three non-
executive directors are also normally recommended, although reports such as Cadbury note this may be
difficult to achieve.
I recommend that the number of executive and non-executive directors is equal to help ensure no one
group dominates the board. This will mean appointing more non-executive directors to SGCC.
Director appointment
At present, Mr Sheppard appoints directors to the board, giving him absolute authority over who is
appointed. This makes the appointment procedure and qualities directors are being appointed against
difficult to determine. Corporate governance suggests that appointment procedures should be
transparent so that the suitability of directors for board positions can be clearly seen.
I recommend that an appointments committee is established comprising three non-executive directors to

ensure there is no bias in board appointments. Formal job descriptions should also be published making
the appointment process more transparent.
Review of board performance
It is correct that the performance of senior managers is reviewed, but this principle should also be
applied to the board. While Mr Sheppard may undertake some review, this is not transparent and it is
not clear what targets the board either met or did not meet.
I recommend that performance targets are set for each director and actual performance assessed against
these on a regular basis. Reasons for underperformance should also be ascertained and where
appropriate, changes made to the composition of the board.
Board pay
At present, board members pay is set by Mr Sheppard. This process breaches principles of good
governance because the remuneration structure is not transparent and Mr Sheppard sets his own pay.
Mr Sheppard could easily be setting remuneration levels based on his own judgements without any
objective criteria.
I recommend that a remuneration committee is established comprising three non-executive directors.

They will set remuneration levels for the board, taking into account current salary levels and the
performance of board members. Remuneration should also be linked to performance, to encourage a
high standard of work.
Internal control
The system of internal control in SGCC does not appear to be reviewed correctly. While external
auditors will review the control system, this review is based on their audit requirement and cannot be
relied on to test the overall effectiveness of the system. The system may therefore still contain
weaknesses and errors.
I recommend that some more formal review of internal control is carried out, perhaps by establishing an
internal audit department, as noted below. The relationship with the companys auditors must also be
reviewed so that the work of the board and the auditors regarding internal control is understood by both
parties.
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Internal audit
SGCC does not have an internal audit department. Given the lack of formal review of internal control in
the company, this is surprising. Good corporate governance implies that the control system is monitored
and that an internal audit department is established to carry out this task.
I recommend that an internal audit department is established, reporting initially to the audit committee
who will monitor internal control and then summarise reports for the board.
Financial statements
There appears to be acceptable disclosure in the financial statements regarding the past results of the
company. However, the board should also provide an indication of how the company will perform in
the future, by a forecast review of operations or similar statement. This is partly to enable investors to
assess the value of their investment in the company.
I therefore recommend that the annual accounts of SGCC include some indication of the future
operations of the company.
Audit committee
There is no mention in the report of an audit committee. Good corporate governance implies that there
is some formal method of monitoring external auditors as well as checking that the reports from the
external auditors are given appropriate attention in the company.
I recommend that an audit committee is established made up from non-executive directors. The
committee will receive reports from the external and internal auditors (as mentioned above) and ensure
that the board takes appropriate action on these reports.
I hope this information is useful. Please contact me again if you require any further assistance.
Sincerely
Ann C. Outent
Note to candidates: An alternative and allowable answer format was to answer sections (a), (b) and (c)
of the question separately. Taking this approach would also allow other valid points in part (b) such as
inability to obtain a stock exchange listing.
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Answer 3 CORPORATE GOVERNANCE
Memo
From: Chief Internal Auditor

To: Board of ZX
Subject: Role of Audit Committee
Date: dd/mm/yyyy
(a)
Areas where the internal audit department can assist the directors with the implementation of
good corporate governance in an organisation include:
Board reports
Reviewing reports to the board and reports produced by the board to ensure that they do
present a balanced and understandable assessment of the companys position and prospects.
The internal audit department will have good knowledge of the operations of the company as
well as access to accounting information. The department can effectively audit board
reports to ensure they are accurate and understandable.
Internal controls
The board need to maintain a sound system of internal control. The internal audit department
will be able to review existing controls and recommend improvements to ensure this objective
is met.
Application of ISA and IFRS
The board need to have a policy for applying appropriate International Statements on
Auditing (ISA) and International Financial Reporting Standards (IFRS) to the organisation.
Internal audit will certainly be aware of new auditing standards and will have the technical
expertise (especially where internal auditors are professionally qualified) to identify changes
required by accounting standards. Amendments to control systems for new auditing standards
and financial accounting systems for new accounting standards can therefore be
recommended.
Communication with external auditors
Under corporate governance regulations, communications with external auditors will

normally be via the audit committee, although the board must maintain an appropriate
relationship with the external auditors. However, internal and external auditors can also work
together to ensure that the internal control system is sufficient; possibly by external audit
delegating work to internal audit, and each auditor reviewing the work of the other auditor.
The board will therefore receive reports from both sets of auditors which will be accurate
because they have been properly checked.
Communication to the board
The internal auditor can also check that appropriate information is provided to the board from
the external auditor. ISA 260 Communications of audit matters with those charged with
governance provides a list of matters which should be communicated to the board and the
internal auditor can work with the external auditor to ensure that this information is provided.
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(b) The advantages of an audit committee include:
Public confidence
Providing increasing public confidence in the creditability and objectivity of published

financial information. This will be particularly important for ZX if listing arrangements go
ahead. While an internal audit department is not normally necessary for incorporated
companies, the provision of that department will provide additional confidence in the
accuracy of the financial statements and hopefully make ZX an attractive investment.
Financial reporting
Supports the directors in fulfilling their financial reporting obligations. The directors have to
prepare financial statements for ZX. The committee can assist by checking the financial
statements to ensure that they comply with appropriate reporting requirements. This is
especially important where the board do not have detailed knowledge of accounting
requirements.
Communication
Enhancing the role of ZXs external auditors by providing an appropriate channel of

communication. Use of the audit committee will enable the external auditor to discuss issues
with the financial statements with the internal auditor, prior to providing a final summary of
key points to the board.
Friend of the Board
The audit committee may also act as a critical friend to the board by monitoring the work of
the board and providing helpful guidance, where corporate governance requirements do not
appear to be being met. The audit committee should have detailed knowledge of corporate
governance as part of its monitoring function of the company and can share this with the
board who may not have the time to obtain detailed information.
The disadvantages of an audit committee include:
Lack of understanding of function
As the directors in ZX do not have much knowledge of corporate governance, they may see
the additional involvement of the audit committee as a threat to their authority or taking away
some of their responsibilities. This memo has hopefully outlined the advantages of an audit
committee in supporting the work of the directors, removing this as a problem.
Role of non-executive directors
As the audit committee will be made up mainly from non-executive directors, the board may
see this as a means of decreasing their power and possibly letting other people run the
company. Again, the audit committee must be seen as fulfilling a supporting role for the main
board. It will utilise the special knowledge of account production and internal controls from
the external auditor and business non-executives to provide appropriate review of information
being given to the board.
Cost
The audit committee will increase the expenditure of the company as the non-executive
directors will require some remuneration due to their additional responsibilities. While this
cannot be avoided, the benefits of the committee in terms of providing assistance to the board
and raising the profile of ZX ready for possible listing must not be forgotten.
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Answer 4 FRAUD AND COMPLIANCE SEMINAR
(a) Missing share certificates
The auditors must treat this matter as extremely serious. Not only has a senior executive
perpetrated an illegal act, he has also been guilty of deliberately attempting to mislead the
auditors.
The auditors must report the matter immediately to the audit committee, if there is one, or
otherwise to the full board of directors (ISA 240). A criminal offence has been committed in
the theft of the shares and in attempting to mislead the auditors. The auditors would expect
appropriate action to be taken. Any further course of action depends on the action taken by
the directors.
If the directors do not take appropriate action, such as reporting the matter to the police, the
auditors must consider the desirability of continued association with the company. Failure to
take action would make the directors a party to the wrongdoing involving, as it does, money
for which they have a responsibility to the shareholders.
In most jurisdictions the auditors do not normally have any responsibility for reporting the
matter to third parties except in the public interest or where there is some direct legal duty
imposed on auditors. Their duty of confidentiality prevents their taking further action.
However, on resigning, they can take the opportunity to reveal their concerns in any
communication accompanying their resignation. They may also respond appropriately to
professional enquiries from auditors nominated to replace them. However, they need to
obtain legal advice on the form of such communication to avoid the risk of action for breach
of confidence by the company or even defamation by the finance director.
If the directors do take appropriate action, the auditors must consider their position with
respect to the current audit engagement. The finance director is a key person with respect to
representations on which the auditors would have relied. Now that the credibility of that
officer is in doubt, the necessary level of professional scepticism becomes much greater.
Such an official has the authority to override almost any control and is in a position to conceal
such actions. The control environment must be regarded as being wholly ineffective and
inherent risk assessed as high. Extended substantive procedures will now need to be
performed in all areas that could have been manipulated by the chief financial officer.
Providing sufficient appropriate evidence is available then there would be no effect on the
auditors report. It is possible, under the circumstances, that the auditors may be unable to
reassure themselves that further misstatements are not present. In this case they would need
to issue an except for scope limitation qualified auditors report.
(b) Product safety
The auditors have no duty to search for all instances of non-compliance with all applicable
laws and regulations. However, in addition to laws and regulations directly pertaining to
financial reporting, the auditors also have a duty (ISA 250) to become familiar with any
particular laws and regulations breaches of which might result in the company no longer
being a going concern. Moreover, in this case, they have already become aware of the
possible breach. Their suspicions are aroused and they are under a duty to investigate the
matter further.
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The finance director may be right in claiming the matter is of no consequence, but the fact of
attempting to conceal the evidence from the proper authorities must arouse suspicions that the
matter is serious. The auditors need to obtain independent expert advice on the implications
of the matter. If the company denies access to an independent expert the auditors may
consider, at the very least, issuing an except for scope limitation qualified auditors
report. If the expert confirms suspicions and the effect is potentially material, at the very least
the auditors would require full provision to be made, failing which an except for
disagreement qualified auditors report would be necessary (ISA 250).
If the auditors suspicions are confirmed and the effect is material, the auditors would
normally report the matter to the board of directors and to the audit committee, if the
company has one. In this case, however, the board is implicated in the attempt to cover up the
evidence, so the auditors would report solely to the audit committee.
Again legal advice needs to be sought on whether the actions of the board are illegal. If so,
then they may consider it desirable to resign from the audit. Moreover, consideration must be
given to the consequences of the continued supply of unsafe goods. It is likely the auditors
have a case for alerting the appropriate authorities in the public interest which overrides their
duty of confidentiality to the client legal advice must be sought before doing so.
(c) Understatement of royalties
This suspected fraud differs in being perpetrated by the company and not by employees
against the company. The auditors duty of confidentiality to the company prevents them
from communicating their suspicions to the authors. However, the company has a liability
under the terms of the royalty agreements which must be provided for until extinguished by
the statute of limitations or other limitation on the rights of creditors to sue for amounts due.
The auditors would possibly seek legal advice on whether the companys action was illegal,
such as a conspiracy to defraud the authors or false accounting to obtain a pecuniary
advantage. If the directors actions are illegal the auditors would expect the directors to pay
the amounts due in full. If the directors refuse, the auditors should consider resigning.
If the action is not illegal, it is certainly unethical, and the audit will be affected in two ways.
Firstly, if the amounts are material and the company fails to make adequate provisions within
the financial statements, the auditors must issue an except for disagreement qualified
auditors report (ISA 240). Secondly, the auditors will need to revise their assessment of
inherent risk at the entity level. They would need to increase the tolerable level of detection
risk and perform a higher level of substantive procedures than previously would have been
considered necessary (ISA 240).
(d) Unclaimed wages
If there is no immediately apparent explanation, such as an employee on long-term sick leave,

the circumstances arouse suspicions that the employee is fictitious possibly a former
employee whose resignation the supervisor has deliberately withheld from the personnel
department. If the amount is wholly immaterial, the auditor has no duty to investigate the
matter further.
However, the auditor does have a duty to communicate suspicions promptly to an appropriate
level of management and to see that the matter is properly investigated (ISA 240). If the
auditor is not satisfied that a proper investigation is performed, it is possible that the level of
management to which the suspicions are communicated is also implicated in the fraud. The
matter becomes more serious and must be reported to the audit committee or board of
directors.
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Answer 5 STONE HOLIDAYS
(a) Internal audit function: risk of fraud and error
The internal audit function in any entity is part of the overall corporate governance
function of an entity. Corporate governance objectives include the management of
the risks to which the entity is subject that would prevent it achieving its overall
objectives such as profitability. Corporate governance objectives also include the
overarching need for the management of an entity to exercise a stewardship function
over the entitys assets.
A large part of the management of risks, and the proper exercise of stewardship,
involves the maintenance of proper controls over the business. Controls over the
business as a whole, and in relation to specific areas, include the effective operation
of an internal audit function.
Internal audit can help management manage risks in relation to fraud and error, and
exercise proper stewardship by:
(1) commenting on the process used by management to identify and classify

the specific fraud and error risks to which the entity is subject (and in
some cases helping management develop and implement that process);
(2) commenting on the appropriateness and effectiveness of actions taken by

management to manage the risks identified (and in some cases helping
management develop appropriate actions by making recommendations);
(3) periodically auditing or reviewing systems or operations to determine

whether the risks of fraud and error are being effectively managed;
(4) monitoring the incidence of fraud and error, investigating serious cases
and making recommendations for appropriate management responses.
In practice, the work of internal audit often focuses on the adequacy and
effectiveness of internal control procedures for the prevention, detection and
reporting of fraud and error. Routine internal controls (such as the controls over
computer systems and the production of routine financial information) and non-
routine controls (such as controls over year-end adjustments to the financial
statements) are relevant.
It should be recognised however that many significant frauds bypass normal internal
control systems and that in the case of management fraud in particular, much higher
level controls (those relating to the high level governance of the entity) need to be
reviewed by internal audit in order to establish the nature of the risks, and to
manage them effectively.
(b) External auditors: fraud and error in an audit of financial statements
External auditors are required by ISA 240 The Auditors Responsibility to Consider
Fraud in an Audit of Financial Statements to consider the risks of material
misstatements in the financial statements due to fraud. Their audit procedures will
then be based on a risk assessment. Regardless of the risk assessment, auditors are
required to be alert to the possibility of fraud throughout the audit and maintain an
attitude of professional skepticism, notwithstanding the auditors past experience of
the honesty and integrity of management and those charged with governance.
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Members of the engagement team should discuss the susceptibility of the entitys
financial statements to material misstatements due to fraud.
Auditors should make enquiries of management regarding managements

assessment of fraud risk, its process for dealing with risk, and its communications
with those charged with governance and employees. They should enquire of those
charged with governance about the oversight process.
Auditors should also enquire of management and those charged with governance
about any suspected or actual instance of fraud.
Auditors should consider fraud risk factors, unusual or unexpected relationships,

and assess the risk of misstatements due to fraud, identifying any significant risks.
Auditors should evaluate the design of relevant internal controls, and determine
whether they have been implemented.
Auditors should determine an overall response to the assessed risk of material

misstatements due to fraud and develop appropriate audit procedures, including
testing certain journal entries, reviewing estimates for bias, and obtaining an
understanding of the business rationale of significant transactions outside the
normal course of business. Appropriate management representations should be
obtained.
Auditors are only concerned with risks that might cause material error in the
financial statements. External auditors might therefore pay less attention than
internal auditors to small frauds (and errors), although they must always consider
whether evidence of single instances of fraud (or error) are indicative of more
systematic problems.
It is accepted that because of the hidden nature of fraud, an audit properly

conducted in accordance with ISAs might not detect a material misstatement in the
financial statements arising from fraud. In practice, routine errors are much easier to
detect than frauds.
Where auditors encounter suspicions or actual instances of fraud (or error), they
must consider the effect on the financial statements, which will usually involve
further investigations. They should also consider the need to report to management
and those charged with governance.
Where serious frauds (or errors) are encountered, auditors need also to consider the
effect on the going concern status of the entity, and the possible need to report
externally to third parties, either in the public interest, for national security reasons,
or for regulatory reasons. Many entities in the financial services sector are subject to
this type of regulatory reporting and many countries have legislation relating to the
reporting of money laundering activities, for example.
(c) Nature of risks arising from fraud and error: Stone Holidays
Stone Holidays is subject to all of the risks of error arising from the use of computer
systems. If programmed controls do not operate properly, for example, the
information produced may be incomplete or incorrect. Inadequate controls also give
rise to the risk of fraud by those who understand the system and are able to
manipulate it in order to hide the misappropriation of assets such as receipts from
customers.
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All networked systems are also subject to the risk of error because of the possibility
of the loss or corruption of data in transit. They are also subject to the risk of fraud
where the transmission of data is not securely encrypted.
All entities that employ staff who handle company assets (such as receipts from
customers) are subject to the risk that staff may make mistakes (error) or that they
may misappropriate those assets (fraud) and then seek to hide the error or fraud by
falsifying the records.
Stone Holidays is subject to problems arising from the risk of fraud perpetrated by
customers using stolen credit or debit cards or even cash. Whilst credit card
companies may be liable for such frauds, attempts to use stolen cards can cause
considerable inconvenience.
There is a risk of fraud perpetrated by senior management who might seek to lower
the amount of money payable to the central fund (and the companys tax liability)
by falsifying the companys sales figures, particularly if a large proportion of
holidays are paid for in cash.
There is a risk that staff may seek to maximise the commission they are paid by
entering false transactions into the computer system that are then reversed after the
commission has been paid.
Answer 6 MANLY
(a) Removal from office
(i) Removal by management
The financial statements being reported on represent a statement of accountability by

management and directors to those on whose behalf they exercise their function, that is the
shareholders, in the case of an incorporated business. The ability of management to control
the appointment of auditors threatens to undermine the independence of the audit. They can
effectively evade an unsatisfactory auditors report by dismissing the auditor. Even where the
right to appoint (and remove) auditors is in the hands of shareholders or members,
management are often able to influence the exercise of that function.
There are a number of safeguards available to auditors to minimise the extent of the problem.
Not accepting appointment where there is reason to suspect management might seek
to dismiss the auditor to evade an unsatisfactory report.
Communicating with predecessor auditors to ascertain if such reasons lie behind the
proposed change of auditor.
Adhering strictly to professional independence rules to ensure an ability to

withstand management threats of removal from office in an attempt to dissuade
auditors from modifying their report.
Taking full advantage of whatever statutory protection exists against removal from
office such as a right to communicate with shareholders where a change in
appointment is proposed by management.
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Adhering to professional rules relating to providing advice to non-audit clients,

which might put undue pressure on their auditor. Without discussing all of the
issues with the current auditors, the other firm in this question appears to be acting
in breach of this rule.
(ii) Audit committee
It is now a requirement under many listing jurisdictions for listed companies to have an
independent audit committee. The role of the committee is to oversee the integrity of the
financial reporting controls and procedures implemented by management, to protect the
interests of shareholders and other stakeholders.
For example, under the OECD Principles, the audit committee should be responsible (or at
least recommend as required by the UK Combined Code) for the appointment, re-
appointment and sacking of the external auditors.
This therefore clarifies that the external auditors are responsible to the shareholders and not
directly to the executive management of an entity.
All material audit findings should be discussed with the audit committee, as well as the
executive directors. If the audit committee accept the auditors findings and the need to
qualify, then it is unlikely that they would also recommend sacking the auditor.
(b) Provision of other services
(i) Rules of Professional Conduct
An auditor should not provide accountancy services to listed or public interest

company audit clients except of a purely mechanical nature such as drafting the
statutory financial statements.
Where accountancy services are provided to other company audit clients, the client
should accept full responsibility for the records, the assistance should not extend to
management decision making and a full audit must also be undertaken.
In the provision of other services, care must be exercised that the service is limited
to providing advice and not the exercise of management functions. This applies
particularly in providing executive recruitment services. The service should be
limited to identifying a short-list and not to making the final selection.
Other services should not include the making of specialist valuations, which are to
be incorporated in the audited financial statements.
The provision of non-audit services should not constitute recurring work which
brings total fees received from that audit client to more than 15% of the firms gross
fee revenues or 10% if the client is a listed or public interest company. The reasons
for this are evident from the engagement partners reluctance to qualify the opinion
for fear of angering the management and losing the audit.
Although not over the limit, fees from the provision of non-audit services are,
nevertheless, high. The engagement partners concern is unprofessional and it
would be hoped that professional accountants would be more objective.
Nevertheless, it illustrates concerns that would arise in the minds of users of

financial statements if it is seen that the auditors are generating substantial fee
income from providing non-audit services to the companies they audit.
1014
(ii) Prohibition of non-audit service provision
The Rules of Professional Conduct state that, in principle, there is no objection to providing
non-audit services to audit clients. However, it is also claimed that the provision of such
services impairs auditor independence. The alleged scenario is as follows:
As auditors, the firm is appointed by and is responsible to the members of the

company.
In providing other services, the firm is appointed by and is responsible to the

management, although an audit committee would advise on the appointment.
Because of the advantages of dealing with just one firm of accountants, the
management tends to prefer to use the audit firm to provide these other services.
If the firm loses the audit, they are likely to lose revenues from the provision of
other services. This is clearly the case here and the audit partners judgement is
strongly influenced by the potential loss of revenue.
The auditors recognise the ability of the management to influence auditor

appointment. Where auditors receive revenues from providing non-audit services,
as in the case of Manly, it is alleged that management may exploit this fact in order
to put pressure on the auditors.
Other services often attract higher fees than audit services. Firms may seek to
secure audit appointments primarily as a means of obtaining contracts for the
provision of more rewarding other services.
For these reasons, it is argued, firms should be forbidden to provide non-audit

services to audit clients, or at the very least, such services are appointed by the audit
committee.
The profession, on the other hand, argues that quarantining audit from the provision of non-
audit services denies companies the right to select their professional advisers. It also imposes
costs in that the audit, necessarily, will become more expensive as will the provision of non-
audit services as the firm providing the services will not have the benefit of knowledge of the
company gained through the audit.
As professionals, it is argued, accountants will not allow their judgement to be influenced by

such considerations and the situation illustrated in the question is an unlikely one. Moreover,
there is bound to be overlap between audit and non-audit services such as advice on internal
control and related matters contained in the management letter.
(c) Rotation
Rotation is the term given to limiting the number of years an individual or a firm is associated
with the audit of a particular client.
As from 2004, the ACCA professional ethics require that that the engagement partner should
be rotated every 5 years and other audit partners every 7 years. The benefit of understanding
of the clients business is outweighed by the possible loss of professional scepticism. In this
case the audit partner has known Manlys chief financial officer for too long to be able to
entertain ideas that he may not be trustworthy. In addition she is in breach of the ACCA
rules.
1015
At a further level it is argued that audit firms should only serve a fixed term of office,
although not part of the requirements of the ACCA. The benefits of securing non-audit work
from clients are substantially reduced if the term of office as auditor is limited to say seven
years. Similarly, efforts to maintain good relations with management possibly to the extent of
condoning questionable financial statements would no longer serve a useful purpose.
The argument against rotation of audit firms is that it imposes additional costs and risks. It is
the first year as auditor that is most costly and also the year the auditor is at greatest risk of
failing to detect misstatement through unfamiliarity with the client. Rotation of audit firms is
statutorily required in some countries.
Answer 7 INTERNAL AUDITOR
(a) Request to alter accounts
The first Fundamental Principle of the ACCAs Rules of Professional Conduct

states that members should behave with integrity in all professional relationships,
and that integrity implies honesty, fair dealing and truthfulness.
It is therefore unethical for members of the ACCA to falsify financial records. To

do so might also constitute a criminal offence and if the public interest or national
security is involved, there may even be a responsibility to report the matter to third
parties, although there is no indication in the question that this is the case. In
practice however, the dividing line between what is acceptable and what is not is
often a difficult one to draw.
The internal auditor should first conduct a thorough review of the internal records to
establish whether or not the company has in fact complied with the banks
requirements. If the company has not done so, the question arises as to whether any
legitimate changes can be made in order to meet the requirements.
The question indicates that the profit figures are significantly affected by the
calculation of the bad debt and depreciation figures. It is not uncommon for changes
to such calculations to be made, although the justification for such changes must be
in order to present the financial position more fairly, and not simply to achieve
targets.
Changes in these calculations do not generally amount to changes in accounting

policy and do not therefore require separate disclosure in financial statements as
required by accounting standards (IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors), unless perhaps the amounts are material, in
which case they might constitute exceptional items (IAS 1 Presentation of
Financial Statements). Only if a change in calculations is justified by reference to a
re-assessment of assets lives perhaps, or because the bad debt provision has been
calculated over-prudently in the past, will it be acceptable to make the changes.
It may be legitimate to move bad debts and certain elements of depreciation from
cost of sales to overheads, thus improving gross margins. This would not amount to
a change in accounting policy but it would be important for the change to be
disclosed if the effect were to mean that the banks conditions were met, and they
would not have been met were the changes not made.
It is essential that the documentation that goes to the bank clearly discloses the
changes, as they are likely to be material to the bank.
1016
The situation might arise where the changes are made and the internal auditor
agrees, subject to proper disclosure being made, or signs relevant documentation,
but at a later stage discovers that the bank has not been properly informed about the
changes. In these circumstances, there is no duty to report the matter to the bank,
and the auditor would be in breach of his duty of confidentiality to his employer if
he did so.
However, I would seriously consider whether to continue in employment with such

a company. I would express my concerns, in writing, at the highest possible level, at
all stages during the proceedings.
(b) Implications for the audit, the auditors report and the relationship between the firm
and client
(i) Implications for the audit of the financial statements
The reasons for the changes in the accounting policy in relation to leases is likely to
be important, because the amounts involved are likely to be material and disclosure
in the financial statements is required by IAS 8. The external auditor should satisfy
himself that the reason for the change is justified in terms of the financial statements
giving a true and fair view.
The external auditor should establish the reasons for the change in the calculation of
provisions in the same way as the internal auditor in (a) above. Whilst a matter may
be material to the bank in the context of the lending decision, it may not be material
to the audit of the financial statements.
If the external auditor believes that these changes are unjustified and symptomatic
of a wider problem, he should investigate any other areas in which inappropriate
changes may have been made, and form an opinion on the view given by the
financial statements as a whole, not just in part.
(ii) Potential effect on the auditors report
The fact that the chief financial accountant is on holiday and that the internal auditor
is unavailable is suspicious in itself. If the auditor cannot obtain adequate
information and explanations from the company then he is required to say so in the
auditors report, which will be qualified. The external auditor should warn senior
management of the client of this possibility, at the earliest possible opportunity,
preferably in writing.
Furthermore, if there is significant doubt about the companys ability to continue as

a going concern, then a modified (but unqualified) audit report may be required
under ISA 570 Going Concern (provided that the matter is properly disclosed), or
a qualified report if the matter is not properly disclosed.
(iii) Implications for the continuing relationship between the audit firm and the client
If the auditor considers that the client lacks integrity, or does not have a proper
regard for accounting standards and disclosure requirements, the firm should
consider whether it is appropriate to continue the relationship with the client. It may
be preferable to discontinue the relationship.
1017
Answer 8 CLIENT CONFIDENTIALITY
(a) Disclosure of information relating to clients to third parties
Auditors are permitted or required to disclose information about their clients to third
parties without their knowledge or consent in very limited circumstances.
Generally, auditors can be required to, or are permitted to, disclose information to
certain regulatory bodies, including certain specialist units within police forces
under legislation. Such legislation in many countries includes financial services
legislation, legislation concerning banks and insurance companies, legislation
concerning money laundering and legislation concerning the investigation of serious
fraud or tax evasion.
Auditors are also permitted or required to disclose information where they are
personally involved in litigation, including litigation that involves the recovery of
fees from clients, or where they are subject to disciplinary proceedings brought by
ACCA or similar professional bodies.
Auditors are also permitted to disclose information where they consider it to be in

the public interest or in the interests of national security. Factors to take into
account include the seriousness of the matter, the likelihood of repetition and the
extent to which the public is involved. This right is rarely used in practice.
(b) Response to requests
It is not unusual in practice for various bodies to request information from auditors
informally because it relieves them of the obligation to obtain the necessary
statutory authorities which may be time consuming or difficult.
Auditors must not disclose information without the consent of the client or unless
the necessary statutory documentation is provided by the person(s) requesting the
information.
Unless the auditor has reason to believe that there is a statutory duty not to inform
the client that an approach has been made, the client should first be approached to
see if consent can be obtained, and to see if the client is aware of the investigations,
as should normally be the case. The auditor should ensure that the client is aware of
the fact that voluntary disclosure may work in the clients favour in the long run, but
if the client refuses, the auditor should inform the client if the auditor has a statutory
duty of disclosure.
Auditors should consider taking legal advice in all of the cases described.
Where auditors are made aware of potential actions against the client that may have
an effect on the financial statements, they must consider the effect on the audit
report. If the client is aware of the investigation, auditors will be able to seek audit
evidence to support any necessary provisions or disclosures in the financial
statements.
The auditors should consider whether the suspected fraud relating to the managing
director relates to the company and affects the financial statements.
1018
Auditors will be in a very difficult situation if they become aware of an action that
may materially affect the financial statements, but where the client is not, and where
auditors are under a statutory duty not to inform the client. This situation will not be
improved by the resignation of auditors as they may be obliged to make a statement
on resignation. This puts auditors in a very difficult position and legal advice is
essential in such circumstances.
Tax authorities normally have powers to ask clients to disclose information

voluntarily. Such voluntary disclosure is often looked on favourably by the tax
authorities and the courts. Tax authorities normally also have statutory powers to
demand information from both clients and auditors. The same is generally true of
environmental and health and safety inspectors.
The power of the police to demand information is sometimes less clear and auditors
and clients should take care to ensure that the appropriate authorities are in place.
Those sections of the police investigating serious frauds usually have more powers
than the general police. It is unlikely that trade union representatives have any
statutory powers to demand information.
Answer 9 MELTON MANUFACTURING
(a) Investigations and practical and ethical matters to be considered
Eligibility the firm should be recognised to provide audit services (eg a firm of
Chartered Certified Accountants) and the reporting partner should hold a recognised
qualification (eg be a member of the Association of Chartered Certified
Accountants and hold a practising certificate). The firm should have adequate
professional indemnity insurance (PII) cover.
The reason for the change in auditor whether it is just that the directors believe
they do not receive a cost effective service from the existing auditor. There may be
problems with the level of the audit fee or the existing auditor may want to modify
his auditors report (which the directors are trying to prevent).
Previous years audited accounts. If the auditors report is modified, it indicates that
the audit has a higher than normal risk. From these accounts it may be possible to
assess:
whether the company appears to be having going concern problems (eg by

calculating appropriate ratios, eg debt/equity ratio);
if there could be weaknesses in the system of internal control (because the

company is small or has a dominant proprietor).
With a manufacturing company there are likely to be more problems with the
valuation of inventory, but there would be less risks over sales and purchases as
they are likely to be on credit. There could be problems with obsolete plant and
equipment.
The size of the audit client and the fee compared with other clients. The Guide to
Professional Ethics says that an auditors independence may be compromised if the
fee from a single client exceeds 15% of the total practice income (10% for listed
and other public interest companies).
1019
This does not appear to be a public company, but for a public company the auditor
should not normally both prepare and audit the financial statements. For other
companies, if the auditor both prepares and audits the financial statements, it is
desirable that these are carried out by different staff.
Independence issues in particular, shares should not be held in the client company.
(Any shareholdings should be disposed before being appointed as auditor.) Close
family and business relationship with any directors of the company would also
impair objectivity.
Fees should be sufficient to provide an acceptable return. An inadequate fee

could result in insufficient audit work being carried out and thus increase the audit
risk.
Prior experience of the manufacturing industry and auditing companies in this

industry. Without such experience the auditor may not have the skills necessary to
audit inventory, impairment of plant and equipment, etc. Thus, the invitation to
accept the audit appointment would need to be declined.
Whether staff with special skills (eg of computer-aided manufacturing design) or

external specialists may be required to carry out certain aspects of the audit.
Whether Melton Manufacturing will give permission to communicate in writing

with the retiring auditor. If the prospective client refuses, the nomination should be
refused.
With permission, the retiring auditor will be contacted and asked if there are any
professional reasons why the appointment should not be accepted.
If the company has not paid the retiring auditors fees, the appointment can be
accepted. However, if it suggests that Melton is a bad payer it can obviously be
declined.
(b) Letter of engagement
(i) Importance
The main reason why it is important that an auditor should send a letter of
engagement to the client is that it explains the duties of the auditor: and the contract,
which exists between the auditor and the client. If no letter of engagement is sent,
disputes and misunderstandings may arise about the auditors duties.
The letter of engagement explains that the auditors duties are governed by the
relevant legislation and cannot be limited by the company. Also, the auditor reports
to the shareholders (and not the directors) whether the financial statements show a
true and fair view.
Further, it explains the directors responsibilities, particularly that they are

responsible for preparing the financial statements (although the auditor can prepare
the financial statements for the directors, if requested) and for ensuring there are
proper systems of internal control to prevent or detect errors, irregularities and
fraud.
1020
The auditors are only responsible for giving an opinion on the financial statements.
They are not responsible for detecting small errors and fraud, but their audit
procedures should have a reasonable expectation of detecting material errors and
fraud.
Finally, the engagement letter explains that the fee is based on the time spent by
partners and staff in carrying out the audit.
It is important that the auditor obtains the directors agreement of the letter of
engagement and that a revised letter is sent when there are significant changes to the
terms of the existing letter.
(ii) Main contents
The letter is written on the auditors headed paper and is addressed to the directors
of Melton Manufacturing.
It states the directors responsibilities for keeping proper accounting records and for
preparing financial statements which show a true and fair view. The directors must
make available to the auditor all the records he may reasonably require, and provide
answers to the auditors questions.
The auditor has a duty to report on whether the financial statements show a true and
fair view and comply with any relevant legislation.
Normally, the auditor would report if the financial statements do not comply in any
material respect with accounting standards (IFRSs).
The audit is conducted in accordance with Auditing Standards (ISAs).
Oral or written representations may be asked from the directors concerning various
matters in the financial statements.
The directors are responsible for preventing and detecting irregularities and fraud.
The audit procedures would be designed so there is a reasonable expectation of
detecting material misstatements in the financial statements: However, the audit
should not be relied upon for detecting all irregularities and fraud that may exist.
As auditor, we may provide additional services. For example:
Preparing financial statements;

Lodging returns with the Registrar of Companies;
Investigating irregularities and fraud;
Providing taxation services.
Fees are based on the time spent by partners and staff and on the levels of skill and
responsibility involved.
The letter ends by saying that it remains effective until it is replaced, and it asks the directors
to agree the terms of the letter in writing.
1021
Answer 10 BONDI
(a) Arguments against acceptance of nomination
Rapid growth is often accompanied by inadequate accounting systems and weak

internal controls. Of itself this is not sufficient reason to decline an audit but it
increases inherent risk.
Rapid growth through aggressive take-overs implies a management philosophy that

is willing to accept risks and this is likely to apply to controls as well. Again this
increases inherent risk.
Failure to take action against employee fraud brought to their notice by the auditors
is more serious. This fosters a visible culture of unethical behaviour that is likely to
permeate the company and to be shared by all employees. This will result in a weak
control environment.
Introduction of a new computer system must be undertaken very carefully. In

addition, an unnecessarily complicated system is one of the warning signs of fraud.
Such a computer system may be difficult to audit.
Aggression against audit staff is a well known device for concealment of top
management fraud. There are many documented examples of audit failure through
fear of the audit staff to query management explanations.
The impending public listing means that the company is under pressure to show an
improving performance but also means that the work of the auditor will come under
increasing scrutiny. There are always significant risks in accepting an audit under
such terms.
Arguments for accepting nomination
As a larger firm your firm is likely to have the capability of influencing the directors of Bondi
and persuading them of the benefits of a more ethical style of business. This will benefit the
companys shareholders. If your firm rejects the audit they are likely to appoint a less
reputable firm. This will not be in the shareholders interest and may discredit the profession.
(b) Matters relevant to obtaining knowledge for development of the audit plan
Employee frauds
More information is needed about the alleged employee frauds. In particular the
specific control weaknesses that were exploited and whether any changes have since
been made to the accounting and internal control systems.
The current positions held by the guilty employees and whether they have access to
assets and accounting records. Also, whether they are adequately supervised
especially if a lack of segregation of duties is apparent.
Computer system
Particular attention should be given to the control environment relating to computer

systems and to the evaluation of general (IT) and application controls.
The audit team should include sufficient computer audit specialists.
1022
Tests of controls could include the use of test data or other computer assisted audit
techniques.
Contracts with manufacturers
Examine the terms of contracts and the strategies adopted by the company for
securing maximum benefit from them.
An industry specialist may provide evidence regarding the problems encountered by

manufacturers and dealers in confirming compliance with these contracts.
As the incentive schemes may have accounting implications (eg 0% finance) the
commercial substance as well as the legal form of the transactions with the
manufactures must be understood and the impact on the financial statements
assessed.
(c) Misstatement
As this appears to be a fraud against the government through falsification of

accounting records, the evidence that the falsification of the records is deliberate
and not an accidental consequence of a poorly designed computer system, must be
documented.
The matter must be discussed with management. Management must be asked to:
correct the fictitious records;

make full provision for all taxes including any penalties for which they are
potentially liable; and
make a full disclosure to the taxation authorities.
If management refuse, the audit opinion should be qualified if the amount of taxes
not provided for, if material. (However, the auditors report should not, for
example, accuse the directors of impropriety.)
The auditors duty of confidentiality prevents the auditor from raising the matter
with the taxation authorities. Therefore, it may be most appropriate to resign from
the audit if management refuse to put a stop to the malpractice. Any written
statement of circumstances required on ceasing to hold office could allude to the
matter but would need to be carefully worded, probably with legal advice, to avoid
accusing the directors of fraud and exposing the firm to a charge of defamation.
Answer 11 PLANNING DOCUMENTATION
(a) Overall strategy v Audit plan
These documents are prepared and updated during the planning process, which is an ongoing
process throughout the audit.
The audit strategy sets the scope, timing and direction of the audit, and helps guide the
development of the more detailed audit plan. For example:
Determining the scope of the audit engagement, covers the financial reporting
framework used, industry-specific law and regulation requirements, governance
requirements, locations of the components of the entity (may have different
requirements), terms of engagement, client assistance.
1023
Ascertaining the reporting objectives deals with the timing of the audit and
communications required, deadlines for interim and final reporting; key dates for
expected communications with management and those charged with governance.
Establishing the direction of the audit deals with, for example, determination of
appropriate materiality levels, preliminary identification of areas where there may
be higher risks of material misstatement, preliminary identification of material
components and account balances, evaluation of whether the auditor may plan to
obtain evidence regarding the effectiveness of internal control, identification of
recent, industry, financial reporting or other relevant developments impacting upon
the entity.
The process of establishing the audit strategy helps the auditor to ascertain the nature, timing
and extent of resources necessary to perform the engagement
The detailed approach for the nature, timing and extent of the audit procedures is set out in the
audit plan.
The plan is more specific and concerns the principal audit areas, eg tangible assets, inventory,
revenue cycle (ie sales, receivables and cash receipts), subsequent events and going concern.
An audit program typically contains:
Audit objectives eg To ensure inventory is materially correctly stated;
Audit procedures eg attendance at physical inventory count;
Timing of tests of control (usually interim audit procedures) and substantive

procedures (usually at the final audit).
The audit program has to be much more detailed than the overall strategy in order to serve as
a set of instructions.
(b) Standardized audit programs
Tutorial note: The Q refers only to the use of standardized AUDIT PROGRAMS and not
working papers in general. Thus references to the use of standard letters and
documentation other than programs are not relevant to answering the question set.
Advantages
Their use can lead to more efficient planning in identifying the audit objectives and
adopting an approach based on these objectives. Greater assurance as to the
completeness of the audit approach is obtained than if it were started from scratch.
Planning can be undertaken by less senior staff.
Standardised programmes facilitate delegation to junior staff and help to instruct in

basic audit techniques. They help to ensure that all assignments are planned and
conducted to a consistent quality.
A standardised approach makes the review of audit working papers easier.

Programmes may include sections to be completed, thereby reducing the need for
separate supporting working papers.
1024
Disadvantages
Standardisation may lead to an overly mechanical approach. This may stifle

initiative because an alternative, more efficient approach may not be considered.
No account is taken of the particular circumstances of the individual enterprise.

This decrease in the use of professional judgement for a particular assignment might
result in over-auditing low risk or immaterial areas.
There is a risk that sufficient, relevant and reliable audit evidence may not be
obtained. For example, where alternatives to tests not applicable to a particular
client, are not considered.
Conclusion
Standard audit programmes may be useful on certain assignments to improve audit

efficiency but they cannot replace the need for professional judgement.
(c) Information in working papers relating to attendance at physical inventory count
Viewcos physical count arrangements and instructions should be obtained before

attending the count:
to assess the adequacy of the clients planned procedures; and

to ascertain whether clients staff are carrying out their instructions
properly.
Pre-selected (eg high value) items chosen to ensure that an adequate proportion of
the final inventory value is tested (to conclude satisfactorily on the population).
Results of test counts (ie serial/component references and quantities) provide

evidence as to the completeness and accuracy (or otherwise) of the count records (ie
rough count sheets). Test counts also enable the auditor to assess whether the
clients count procedures and controls are working properly.
The sequence of rough count sheets issued and used will detect any additional items
being included subsequent to attending the count.
Inventories identified as damaged, obsolete or slow-moving must be detailed to

assess the adequacy of allowances/provisions for items with net realisable value less
than cost.
Items owned by third parties must be recorded to ensure exclusion from the final
inventory valuation sheets.
Last goods movement document references for 31 December 2008 (ie goods
received note, stores requisition, despatch note/sales invoice) are needed to check
the accuracy of the year-end cut-off.
Movements, if any, during physical inventory counting to ensure items are not
omitted or double-counted in error.
1025
Other points
A floor plan (sketch) of central warehouse should ensure complete coverage (by
management and auditor) of the physical inventory count.
Details (eg serial numbers) of finished goods held by third parties are required to
confirm the validity of their inclusion in the final inventory value.
The degree of assembly of incomplete TVs and VRs must be noted to assess
appropriateness of stage of completion used in valuing WIP.
Instances where the clients procedures have not been satisfactorily carried out (eg
damaged items not set aside) will be required for the report to management with
recommendations for improvements (eg in standing instructions for physical
counts).
Answer 12 BESTWOOD TRADING
(a) Audit working papers
(i) Contents
The permanent audit file contains information which is relevant to many years audits. Its
contents can include:
the letter of engagement;
the legal and organisational structure of the company, memorandum and articles of
the company;
a history of the company, a description of its business, products, markets,

production facilities, workforce, major suppliers, major customers;
details of statute/regulations under which the business operates, regulatory reports,

related parties and past transactions;
details of directors and senior staff, non-executive directors, major shareholders,

financing arrangements;
copies of previous years financial statements with key ratio analysis/trends (eg over
five years) and commentary on the figures, performance measures
details of the companys business control system, internal audit, risk procedures,
control environment, accounting systems, control procedures, flowcharts, completed
control and evaluation questionnaires, Business Risk Assessments;
details of the companys locations, relevance to audit and visits made (perhaps on a
rotational basis and rotational testing of controls)
copies of significant documents, including long-term contracts, finance leases

minutes of significant board meetings;
past management letters and responses, summary of past matters for attention of
partner and actions taken, past qualified audit reports;
the knowledge base of the client, its environment and business operations.
1026
The current audit fire contains documents which are relevant to the current years audit. This
information includes:
understanding the entity and its environment updated from prior year and showing
the impact for this year;
evidence of planning (strategy and plan) of the audit including the audit planning
memorandum and briefing of key audit team members;
copies of board minutes, significant management reports, management accounts, the

trial balance and draft financial statements. There should be a reconciliation of any
difference in profit between the draft financial statements and the management
accounts;
consideration of business and audit risk for each area of the audit. This could
include notes on high risk areas of the audit, decisions on sampling approach,
materiality etc;
consideration of fraud indicators;
copies of flowcharts and completed ICQs or ICEs if they are not included in the
permanent audit file;
Tutorial note: It may be preferable to include flowcharts and ICEs or ICQs in the
current audit file when there are changes to the systems in the year.
records of the audit work done (effectiveness of controls, transaction work,
substantive work and analytical review), problems encountered and conclusions
reached (see below);
by whom the schedules have been prepared and reviewed (as evidenced by their
initials) and when (ie date);
evaluation, review and closedown procedures, going concern, subsequent events,

IFRS checklists
a section for the managers and partners attention which lists significant problems
encountered in the audit. This will include a summary of unadjusted errors. This
section will direct the partner to these important areas, and to decide whether the
financial statements need amending or a qualified auditors report should be given;
details of discussions with management and audit committee;
partner completion, approval and sign off.
(ii) Referencing system
Recording audit work in working papers is usually divided into sections which have a
reference letter or number. For instance, the letter R could be used for Sales and
Receivables work. Thus, for any audit carried out by the firm, any member of staff wanting
to look at audit work on Sales or Receivables can go to the section with the letter R.
1027
Within each section, there will be a sub-division whereby verification of receivables will be in
pages Rl to 099 and audit work on the sales system will be on pages R100 to R199 (ie tests on
statement of financial position items will be on pages 1-99 and tests on accounting systems
will be on pages 100-199 these numbers will be preceded by a letter which signifies the area
of the audit, with R being for sales and receivables).
The front page of the R section of the audit file will show the value of receivables in the
statement of financial position, and references on the make-up of receivables will be to the
pages where details of verification of these items is included in the working papers. For
instance, the total value of receivables will be broken down into:
verifying the gross value of trade receivables (eg on page R2 of the audit file);
checking the bad and doubtful debt provision (eg on page R5);
audit of sundry receivables and prepayments (eg on page R10).
By using this standardized procedure for referencing audit files, all members of the firms
audit staff, including managers and partners can review each section of the audit in a
systematic manner. This should enable them to come to an appropriate conclusion on the
audit work done and the form of auditors report which should be attached to the financial
statements.
If no standardized procedure is used. the partner would find it time-consuming to find a

particular matter in the audit file. By standardizing audit files, the audit work should be
carried out in a more systematic manner which should ensure a high quality audit is carried
out.
Particularly important sections in audit files include:
conclusions reached in each area of the audit and notes of any significant problems
detected;
matters for consideration by the partner and the summary of unadjusted errors
(which should include significant uncertainties).
(iii) Types of checklists
Internal control evaluation questionnaires (ICE) and internal control questionnaires

(ICQ) for evaluating controls in accounting systems.
Physical inventory count checklists which are used to record work done and to
ensure all aspects are covered.
Companies Act and International Financial Reporting Standards checklists to ensure

the financial statements comply with relevant statutory and professional
requirements.
Audit completion checklists (senior, manager and partner) to help the auditor ensure
all material audit work has been performed and matters considered.
Checklists are important, as they are a means of ensuring that all aspects of the audit work are
carried out. A standard ICE on the sales system would be better than one prepared for each
audit, as the standard ICE will be tried and tested so there will be a lower risk of a matter
being omitted than if the checklist was prepared by the auditor at each audit.
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Types of specimen letters
The engagement letter which the auditor should send to the client (and get agreed by
the client) before the audit is accepted. The contents of this letter should be
reviewed and a new one issued and agreed when there are significant changes in the
auditors responsibilities.
Management letters which are letters sent by the auditor to the company recording
weaknesses found in the audit.
Management representation letter which is a letter drafted by the auditor, but on the
companys letter heading and signed by the directors. It is used to enable the
directors to confirm to the auditor certain matters where the auditor cannot obtain
adequate evidence from other sources.
Bank letter, where the bank states the balances on the companys bank accounts and
other matters.
Direct confirmation letters from trade debtors. The circularisation letter asks trade
debtors of the company to confirm (or otherwise) the balance on the sales ledger.
(b) Reasons why auditors have working papers
As a record of work performed on the audit, and to ensure a consistent, logical and
reasoned approach to audit work by following an audit plan and recording work
performed as the audit progresses.
To provide evidence to external regulatory bodies (eg the ACCA, FRC) that the
audit has been carried out in accordance with ISA and applicable audit regulations.
This evidence will also be required for internal quality control reviews.
To assist the manager in reviewing the audit work, and the partner in coming to an
audit opinion. The audit working papers will provide evidence to the partner of
work done. From the working papers it may become apparent that insufficient work
has been carried out in certain areas and more work is required.
To provide evidence of work done if there is a threat of or action taken against the
auditor for negligence. The audit working papers should provide evidence that
appropriate audit procedures have been carried out and conclusions reached, In the
case of a material doubtful debt, should show the evidence the auditor has obtained
and the matters he has considered in deciding whether the companys estimate of
the bad debt provision is reasonable.
Generally, all audit work should be recorded in the audit working papers. Work performed on
some immaterial items may not be included. However, as is noted in part (c) below, it is
desirable that all audit work is recorded, as an item which may appear to be immaterial may
subsequently become material.
For instance, an item which is checked in a test of controls may not in itself be material, but
an error detected in a test will probably be material in terms of the conclusion reached on the
population (using statistics). To a certain extent, audit working papers are a summary of work
done. So a check performed in a test of control may be signified by an audit tick against the
item, and the tick will be explained at the bottom of the schedule. If some audit work is
thought to be unimportant (and thus there is the possibility of it not being recorded) the
auditor should consider whether it is necessary to carry out that work.
1029
It is important to record audit work as, if legal action is taken against the audit firm, it may be
necessary for the firm to demonstrate that items have been checked and support the
conclusions reached.
(c) Late banking of cash receipts
If the late banking of receipts of $7,000 was a fraud at 31 October 2007, this is 4.4% of profit
before tax, so it is unlikely to be material. When the fraud was found in May 2008, it
amounted to 11.25% of profit before tax which is probably material. If the auditor did not
report the late banking to the company which he found at 31 October 2007, then he could be
held (partially) responsible for the loss between 31 October 2007 and when it was found in
May 2008. The loss during this period is $11,000, or 6.9% of profit before tax, which may be
material.
(i) Reported in the management letter
It appears the auditor is not negligent. The only matters which might be unsatisfactory in the
auditors work are:
it appears he has not determined whether a fraud was being carried out at 31
October 2007; and
the company should have been informed immediately at the time the discrepancy
was found, rather than leaving it to the management letter.
However, both of these criticisms of the auditor appear to be relatively minor. It may not be
possible at todays date to determine whether there was fraud at 31 October 2007, as the
$7,000 of late banking could have been held by the cashier (although this seems unlikely). In
conclusion, the auditor is probably not liable for negligence in this situation. The company
has been warned of the risk of a fraud but appears to have taken no action until May 2008.
(ii) Not mentioned in the management letter
In this situation, the auditor may have some liability for negligence. The late banking of
deposits should have been reported to the company both verbally and in the auditors
management letter. Also, the auditor should have been put upon enquiry by the delay and
investigated the matter further as at 31 October 2007 (or at the date he checked the bank
reconciliation). Thus, the auditor has some liability for negligence for not reporting the
matter to the companys management and not carrying out further procedures.
The auditor could argue the possible fraud at 31 October 2007 was immaterial as it is 4.4% of
profit before tax, but by taking no action on the matter it has increased to 11.25% of profit
before tax, which is material. The auditor should not be held wholly responsible for the extra
loss of $11,000 (between 31 October 2007 and May 2008) as it is probable that the
companys control procedures were inadequate. As the cashier was recording cash received
and preparing the bank reconciliation as well as having custody of the cash received there
was an inadequate division of duties, so another person in the company should either have
prepared the bank reconciliation or checked it. It is apparent that either this check was not
being performed or it was not performed competently. As the auditor was aware of the late
banking of $7,000 of cash receipts and he should have been aware of the weakness in control
over the cashier, the auditor should have reported these problems to the company, even
though the fraud was immaterial at the time of the audit.
1030
Thus, in this situation, the auditor has some liability for the fraud continuing but this is
mitigated by the fact that there was a clear weakness in the division of duties with the cashier,
and the company should have established an effective system of internal check over the
cashiers work. This was either not being performed or not being performed competently.
Thus, the company must accept some liability for the fraud developing. If the case came to
court, reference will probably be made to the audit working papers as one factor in
determining the extent of the auditors liability for negligence.
Answer 13 WORKING PAPERS
(a) Audit programs
Tutorial note: In the context of the Q set, the term audit program should not be confused
with audit software (ie a CAAT).
Design and use
Audit programs are lists of audit procedures to be performed by audit staff in order to obtain
sufficient appropriate audit evidence. The individual procedures are determined after
obtaining an understanding of the entity and its environment and determining the audit
strategy to be followed. The procedures reflect the understanding of the control system and
will incorporate the mix of tests of control and substantive procedures based on the planned
audit approach for each material financial statement assertion.
The program also serves as a means of monitoring and co-ordinating the progress of the audit.
The program should be designed with columns alongside each procedure for staff members to
enter their initials and date on completing the performance of each procedure and to note the
reference of the working paper detailing the results of the tests performed and the conclusions
drawn.
Standardized or tailored
Tutorial note: The Q specifically asked for merits, therefore disadvantages, as well as or
instead of advantages, are not called for.
It used to be common for audit firms to pre-print standardized audit programs; usually one set
for larger entities and another set for smaller entities. The advantages of this approach
include:
A consistent approach to all audits.
Reduced risk of procedures being omitted.
Reviewers could quickly check the progress of the audit being familiar with the
contents of the program.
Although most firms continue to provide model audit programs, these are designed to be
tailored to the specific circumstances of each engagement. The benefits of this approach are:
The design of procedures and the names of the documents and records detailed in
the program match the actual accounting system of the entity.
The balance between tests of control and substantive procedures can be varied to
match the preliminary assessment of inherent and control risk separately for each
major financial statement assertion.
1031
It provides engagement staff with greater control over the audit based on their
knowledge of the entity and of the specific audit risks. This, in turn, results in a
better understanding of the purpose of each procedure since the staff member
performing the procedure will have been involved in designing the program being
followed.
(b) Audit trail
Recording details of evidence examined and leaving a trail that could enable the evidence
procedure to be replicated serves several purposes.
It facilitates the progress of the audit on a day by day basis where a procedure is
performed over several days or by different staff members. By maintaining detailed
records, procedures completed, partially completed and as yet unperformed can be
readily identified.
For example, a variety of tests may be carried out on a sample of purchase invoices.
Each of the sample of invoices is listed, as a row, on a working paper with columns
for the separate tests to be performed on each invoice. Progress is indicated by
recording the results of the test in the appropriate cell.
As in any control procedure, requiring staff to evidence the work performed

provides assurance that the task is likely to be properly performed. If staff members
know that their work could be checked, they are likely to perform it more
conscientiously. One of the risks of auditing, especially where staff are required to
work to a time budget, is that of premature sign-off claiming to have performed
tests that were not properly completed.
The temptation for audit staff to skimp the proper performance of each procedure is
also reduced by requiring them to leave a visible trail on entity records. In the
above example, the invoices selected for sampling would be initialled by the staff
member and where procedures require it, other documents examined and entries in
the records would also be ticked by the staff member.
Marking documents and records provides evidence, to management of the entity,

that a thorough audit has been performed. It also serves to alert entity staff that
their work is subject to audit and adds to the incentives to perform their work
carefully.
Not least is the need to demonstrate proper performance of the audit in the event of
a claim for negligence. Reliance on sample evidence means that it may be
necessary for the audit firm to prove that a properly designed and selected sample
was examined and that failure to detect an error or misstatement was not due to
negligence in the performance of the audit.
Although the level of detail recorded is a matter of judgement, it is usually desirable to

include:
Results of all tests performed.
Details of individual items selected for sampling including an indication of how the
sample was selected.
A tick or some other mark on entity records and documents vouched, traced or
otherwise inspected during the course of specific tests of details of transactions or
balances.
1032
A typical work schedule detailing the audit trail would cover:
the test objective;

accounting policy;
materiality and risk
sampling approach and sample sizes;
work done;
matters arising;
action taken; and
conclusion
Answer 14 PHONES ANYWHERE
(a) Risks associated with the audit
There appear to be considerable risks associated with undertaking the audit. In particular;
Phones Anywhere appears to have a very high inherent business risk.
The low coverage of the country will be a disincentive to new subscribers. Initially,
subscribers will only be those who operate in the town with a population of
1,000,000. The service will not be available when the subscribers are outside that
town. There will be serious doubts about going concern if the company does not
have the financial resources for future developments (to towns with a population of
250,000 in the next year and its planned developments to the year 2011).
The companys plans for extending the network do not appear to be realistic, as
many mobile phones are used on motorways and trunk roads. Motorways will not
be covered until the year 2011, and coverage of other roads is not mentioned. These
plans are likely to be a serious disincentive to new subscribers joining the system,
when competitors cover most of the country. The risk of business failure appears to
be high.
The central computer is pivotal to the organization, as it relays the calls and
calculates the bills for subscribers. Will this computer and its software be reliable?
The consequences of a breakdown of the computer will be very serious. Ideally,
there should be more than one computer running the system, and the system should
be able to continue if one of the computers fails.
What is the capacity of the main computer? With the planned expansion, it is
probable that it will run out of capacity in the near future. Is it possible to expand
the capacity of the computer? Has the cost of upgrading the computer been
included in future forecasts? Will the current software be able to process a large
increase in subscribers, or will it have to be re-written (at substantial cost)?
Is it reasonable to amortise the cost of the relay stations and main computer over six
years? Six years may be realistic for the buildings part of capital expenditure, but
it may be too long for electronic components including the main computer and
transmitters.
Is the discount paid to retailers for the purchase of the phones recoverable? It is
capitalised and amortised over four years. Do subscribers remain connected to a
single operator for as long as four years (if many change in less than four years, this
amortisation period is too long), and are subscribers likely to change their phones
within four years (to update to a more advanced model)?
1033
Paying the executive directors a bonus based on the number of subscribers of the
system could encourage them to obtain as many subscribers as possible (by offering
discounted prices) rather than charging a realistic price which will ensure the long
term future of the company. However, the executive directors should be concerned
with the long-term future of the company, as this will ensure they continue to be
paid (rather than have to find a new job when the company fails).
In view of the planned high borrowings, and future trading losses, there is a very
serious risk the company may not be a going concern. This increases the risk of the
audit firm being sued for negligence. Also, Phones Anywhere will put severe
pressure on the audit firm to give an unmodified auditors report. This pressure will
increase because the audit firm is small and Phones Anywhere is a relatively large
and rapidly growing company.
As an alternative to the company not being a going concern, there is the risk that
other investors may purchase more shares in the company (to provide additional
equity finance) or purchase the company outright from the existing directors (or the
administrator/liquidator). If this occurs, recent financial statements will be subject
to close scrutiny. The standard of audit work will have to be high, and the problems
mentioned above (eg complex computer systems and depreciation rates which may
be inaccurate) could lead to undetected material errors in the financial statements.
Thus, there is a high risk that legal action for negligence could be taken against the
audit firm following a take-over or purchase of shares.
Flotation of the company on the Stock Exchange is a further risk. Immediately

prior to the flotation, audit work carried out will be subject to close scrutiny. The
increase in audit risk must be reduced by an increase in audit work (to reduce
detection risk) increasing the cost of the audit and reducing its profitability. Also,
when the company becomes quoted on the Stock Exchange, it is probable the audit
firm will be replaced as being too small. The majority of companies quoted on
recognised Stock Exchange are audited by one of the big 5 firms.
This is a high technology industry. The technology or customer requirements may

change, which could make parts of the equipment obsolete. Alternatively, it could
be expensive to modify the equipment or software to meet the demands of
subscribers. Is the company currently providing a similar range of facilities to other
mobile phone companies. If its service is not as comprehensive as other mobile
phone companies, it may not be successful in breaking into the market.
This appears to be a very competitive industry. Are the competitors profitable, or

are they making losses to keep prices low to prevent other companies entering the
market? Establishing Phones Anywhere as a major company in the market will
probably require large expenditure on advertising and offering new subscribers a
service at a lower price than competitors. Both of these factors will tend to make
Phones Anywhere unprofitable (as note (j) in the question suggests).
The reputation of the three major shareholders and the executive directors should be
assessed. If they have been directors of companies which have failed, or been
involved in financial or other wrongdoings, this will increase the inherent risk. The
reputation of the financial director and the quality of the accounting records should
also be considered.
1034
(b) Professional and ethical matters
The size of the audit fee. The Association of Chartered Certified Accountants
(ACCA) rules of professional conduct say the fees for audit and other recurring
work paid by one client should not normally exceed I5% of the gross practice
income (and 10% for listed and other public interest companies). If the planned
audit fee is over 15% of the current practice income, the audit should not be
accepted.
However, the rate of expansion of Phones Anywhere will probably be much greater
than the increase in practice income, so the 15% rule may become a problem in the
next few years. When Phones Anywhere becomes a listed company in the year
2011, the audit fee from Phones Anywhere must be less than 10% of the fees of the
practice.
It seems probable that this limit of 10% will be exceeded. In practice, it is

undesirable for the audit fee to approach 15% of the practice income, as reliance on
such a large audit fee could be seen to affect the firms independence.
The audit firm may be able to audit Phones Anywhere at its current size. However,
when the system covers all towns with a population of over 250,000, on occasions
audit work will probably have to cover all areas of the country, and it is most
unlikely that the audit firm will have sufficient staff to perform this work.
Whether the firm is technically competent to perform the audit, and whether the size
of the firm being audited is too large for the experience of the practice. Mobile
telephone companies are very complex and have specialised accounting procedures;
both in terms of the accounting system and the ways matters are treated in the
financial statements (eg the advance payment of $200 given towards the purchase of
phones purchased by new subscribers).
The firm will probably not have experience in auditing the computerised accounting
system which controls calls and generates bills for subscribers. This requires
specialised computer auditing techniques.
The firm may also be unfamiliar with many of the accounting treatments for non-
current assets and may not be able to determine whether the lives given to non-
current assets are reasonable.
This lack of experience will probably mean that the audit will be too high a risk for
the audit firm (ie the firms relative inexperience will mean that a satisfactory audit
cannot be carried out, so there will be a high risk of material misstatements in the
financial statements, which increases the risk of litigation being brought against the
firm).
The audit firm must have adequate professional indemnity insurance (PII) cover.
This is unlikely in view of the size of Phones Anywhere, so there will be an
increased cost of obtaining more PII cover. The insurance company may refuse to
increase the PII cover if it perceives this to be a high risk audit which is exacerbated
by the small size of the firm.
1035
Other matters
The audit partners must have no family or personal relationships with the directors
of Phones Anywhere. These relationships also apply to any staff involved in the
audit. Ideally, none of the firms staff should have relationships with the directors
of Phones Anywhere.
No one in the audit firm should own shares or any investments in Phones
Anywhere.
No one in the audit firm should be a beneficiary or trustee of a trust which holds
shares in Phones Anywhere. The ACCAs rules of professional conduct do allow
employees of the audit firm to be a beneficiary of shares in an audit client, but that
employee must not be employed on the audit of that client.
For trustees, the trust should hold less than 10% of the shares of the company, and
the value of the shares should be less than 10% of the total assets of the trust.
Employees and partners of the audit firm must not vote on the appointment, removal
or remuneration of a firm which is an audit client.
The audit firm should not make a loan to or accept a loan from an audit client
(exceptions to this rule apply where the audit client is a bank or other financial
institution which does not appear to apply in this case).
The audit fee has been considered earlier in this section. However, the audit fee
should be sufficient for the firm to perform the audit to a satisfactory standard.
Thus, it would not be acceptable to offer a very low fee (often called lowballing)
in order to obtain the audit, as this would impose pressure on the time allowed to
carry out the audit. This could lead to inadequate audit work being carried out
which would increase the risk that material misstatements in the financial
statements may not be detected.
Other matters covered by the ACCAs rules of Professional Conduct
When the audit firm is asked to accept the audit appointment, the clients
permission to communicate with the existing auditor must be sought. If this
permission is refused, the firm should decline to accept appointment as auditor.
The audit firm should write to the existing auditor requesting all the information
which ought to be made available to decide whether or not to accept the audit
appointment.
The audit firm should consider the reply from the existing auditor. If the existing
auditor makes adverse comments, further consideration should be given whether or
not to accept the audit appointment.
If the existing auditor does not reply to the letter, a further letter should be sent
giving notice (eg seven days) that if no reply is received in that time, it is
understood that there are no professional or other reasons preventing the firm from
accepting the audit appointment.
Before finally accepting the audit, a letter of engagement should be prepared and the
directors of Phones Anywhere asked to sign it.
1036
(c) Conclusion
From the discussion above, the firm should not offer itself nor accept the appointment as
auditor of Phones Anywhere. The main reasons for this decision are:
Phones Anywhere appears to be too large a company for the firm to audit, and it is
likely to grow faster than the audit firm. The audit fee will probably exceed the
ACCAs limit of 15% of the practice income, and if this is not exceeded now, it is
likely to be exceeded in the next few years.
Phones Anywhere is a specialised company with complex computer systems. It is

possible the firm will not have the skills to perform this work.
The accounting conventions for Phones Anywhere may be unfamiliar to a small

firm, particularly the treatment of the $200 given to new subscribers to purchase the
phones and the lives of the non-current assets. If the firm doe not have the skills to
consider whether these treatments are satisfactory this could lead material
misstatements in the financial statements being undetected.
Phones Anywhere appears to be undercapitalised. Currently, leverage is 20% but

this will increase substantially with expansion of the network and losses in early
years of trading. Thus, there is a serious risk that Phones Anywhere will fail or be
taken over, which could result in the firm being sued for negligence.
The large size of Phones Anywhere and the small size of the audit firm could
compromise the firms independence. Third parties (including shareholders) will
perceive that the firm is not independent (on the relative size criteria), and Phones
Anywhere could bring severe pressure on the firm which would be hard to resist (ie
they will ask for an unmodified auditors report to be given when either a qualified
opinion should be given or an emphasis of matter paragraph included).
The potential listing of the company on the Stock Exchange increases the audit risk,
as there will be greater scrutiny of the financial statements prior to listing, which
could highlight problems in the financial statements.
Finally, because of the large size of Phones Anywhere and the large audit fee,
Phones Anywhere may attempt to squeeze the audit fee. Accepting a reduced
audit fee (rather than losing altogether such a large audit fee) could result in a
reduction in the time to perform the audit and thus increase the risk of not detecting
material misstatements in the financial statements.
Answer 15 BRIDGFORD PRODUCTS
(a) Importance of planning
ISA 300 Planning an Audit of Financial Statements requires that The auditor should plan the
audit work so that the audit will be performed in an effective manner. It goes on to say that
planning means developing a general strategy and a detailed approach for the expected
nature, timing and extent of the audit.
As this is a continuing audit, the general strategy will probably be similar to last years audit.
However it will be modified by problems experienced in last years audit and significant
events which have taken place in the company since last years audit. The timing of the audit
work is important, as time will be wasted if it is planned to carry out audit work when the
appropriate information is not available from the company.
1037
The timing of the audit work will influence the make-up of the audit staff during the audit (ie
the balance between junior and experienced audit staff). It will be necessary to agree a
timetable with the company of when information will be available and this will determine
when the audit work is carried out. Also, the following dates will be important:
the inventory count

when the full financial statements are available for audit
when the financial statements are agreed and signed by the directors and the auditor
the date of the annual general meeting when the financial statements are approved
by the shareholders.
The extent of the audit work in each area will have to be considered. This will be based on a
number of factors, including the materiality of the item and the audit risk based on experience
in previous years audits.
A budget will be prepared which suggests the time which should be spent on each aspect of
the audit and the completion dates of each part of the audit.
During the audit, progress will be compared with the audit plan. Any adverse (and
favourable) variances against the plan will be investigated, and the plan amended if it is
considered appropriate.
Planning an audit is important. One would not build a house without a plan, so one should
not carry out an audit without a plan. The requirement to plan an audit ensures senior audit
staff have considered the work which is required to complete the audit, and the timing of that
work so that it fits in with the dates information is available from the company and the
planned completion date when the financial statements are approved by the directors and the
auditor.
By having a plan, the auditor should take a more considered approach to the audit which will
improve the quality of the audit, and thus both minimise the time spent on the audit and the
overall audit risk. When the audit is carried out, the progress can be monitored against the
plan, and action taken when the audit starts to take more time than expected, both in terms of
staff time and in reaching deadlines.
(b) Matters to be considered and further action
(i) Sales and profits
The companys sales for 10 months are $130 million, which given an annualised sales of
$156 million, is a 41.8% increase over the previous years. The annualised profit before tax is
$4.8 million, compared with $8 million last year, which is a fall of 40%. It appears the
company is increasing sales at the expense of profits.
If profits are falling, the actual profit for the 10 months to 30 November 2008 may be even
less than the $4 million shown by the monthly accounts. The fall in profit indicates problems
which may not be fully reflected in the monthly accounts
(ii) New computerised inventory system
Audit work will have to be carried out on the new computerised inventory control system.
Computer audit specialists within the audit firm will probably have to be used. It may be
appropriate to carry out this work before the year end, so that any problems with the system
can be highlighted and either overcome or allowed for at the year end.
1038
The company says it will not be carrying out an inventory count at the year end, so as auditor
I will have to place considerable reliance on the accuracy of the inventory quantities reported
by the inventory control system. I will have to determine from the company how frequently
they count the inventory, the proportion of the inventory counted at each inventory count, and
the checks they make to the inventory quantities on the computerised system.
If there are a large number of differences between the physical inventory quantities and those
on the computer, inventory counts should be carried out more frequently and on a larger
proportion of the inventory than if differences are infrequent. This information will have to
be determined before the year end, as, if differences are frequent, it may be necessary to carry
out a full inventory count at the year end. Otherwise, there is a high risk the auditors report
will have to be modified.
(iii) Product reliability
Reliability problems with the companys products could result in the following:
Certain inventory being unsaleable, and thus worth less than cost (or even being
worth only scrap value);
Legal claims against the company;
Customers not paying for the products.
Tutorial note: These last two points are mentioned in the question.
Further details will have to be obtained about legal claims against the company and customers
refusing to pay their outstanding balances. Information can be obtained for this by inspecting
correspondence with customers and discussing the matter with the companys staff, including
the company secretary, sales director and the credit controller.
The audit risks with these problems include:
The difficulty in estimating the costs (ie the costs of defending legal claims and
damages which may have to be paid, and the cost of the bad debts).
The risk that there may be more claims and bad debts, which relate to the year under
review, but may not become apparent until after the auditors report is signed.
The value of the faulty inventory held at the year end. The selling price of
inventory sold between the year end and the audit will have to be checked to ensure
it is valued at the lower of cost and net realisable value. There may be problems
determining the value of year-end inventory which is still held at the time of the
audit.
(iv) Extended credit
The large increase in receivables age will have resulted in a large increase in receivables,
from $14.7 million at 31 January 2008 to an estimated $53.3 million at 31 January 2009. The
increase of $38.6 million will probably have come from increased borrowings.
Thus, the increase in the credit period and sales to new customers will result in the following
audit risks:
New customers tend to have a higher risk than existing ones, thus increasing the risk
of bad debts
1039
Increasing the credit period tends to attract customers who are a poor credit risk.
This is for two reasons:
(1) the longer credit limit will reduce the customers cash flow problems; and
(2) it attracts customers who already have cash flow problems, as these
customers are unable to pay other vendors within the shorter credit period
(eg the one month credit period previously allowed by Bridgford)
A potential bad debt, or dispute about a faulty product, may not become apparent until
after the credit period is being exceeded. Thus, it will probably take at least three
months before the doubtful receivable becomes apparent, rather than the one month
with the previous credit period. So, doubtful receivables from sales immediately prior
to the year end may not become apparent until after the auditors report has been signed.
In addition, the actual age of receivables is 1.1 months in excess of the current credit limit (of
three months) compared with 0.6 months over the credit limit in the previous year. This
indicates there may be problems with collection of receivables from customers and thus an
increase in bad debts.
With the large increase in receivables, the company is probably experiencing liquidity
problems. Are the companys borrowing facilities adequate, and is there a risk the company
may not be a going concern?
(v) Staff dismissals
The reasons for the dismissal of the chief financial officer and purchasing manager will have
to be ascertained. Were they carrying out a fraud (separately or together)? or were they
contravening financial procedures? If this was happening, what are the financial
consequences? Is it possible for this type of fraud to recur? Could our audit firm be liable for
not detecting these events?
If the dismissed employees are claiming unfair dismissal and compensation from the
company, the likely outcome from these claims would have to be investigated and an
appropriate provision included in the financial statements. This could be a high risk area of
the audit.
In addition, I will have to consider the consequences of the company being without a
purchasing manager from IS August until the new purchasing manager was appointed. There
is the risk that controls during this period will have been weaker than normal, thus increasing
the risk of a fraud.
The new purchasing manager will take time to become effective in his post, which could
increase the risk of fraud. Also, the wrong products may be purchased, or products may be
purchased at an inflated price. This could mean that some products in inventory at the year
end may be worth less than cost.
The effect of there being no chief financial officer between 15 August and the year end may
mean that financial records and controls may not be as effective as in previous years. The
chief accountant will probably be much busier than when there was a chief financial officer
which could mean that, with less time to prepare the financial statements, the annual accounts
are less accurate and less complete. If the chief financial officer prepared the annual draft
financial statements in previous years, does the chief accountant have the skills and
experience to prepare this years financial statements?
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Answer 16 FIVE DOCK
(1) Investment
(a) Effect on risk
This transaction affects inherent risk at both a specific account balance level and at the entity
level. At the level of the account balance investments there is the risk that the value of the
investment may be misstated.
At the entity level there is the risk that transactions between Five Dock and Burwood may not
give a true and fair view. Moreover, there is the possibility that the Chairman is not acting
wholly in the interests of Five Dock shareholders.
(b) Design of audit procedures
Transactions between Five Dock and Burwood are now known to be between related parties.
There is a possibility they may be deliberately structured to distort reported results in either or
both companies. Such transactions need to be subjected to extra scrutiny to ensure that their
disclosure and the valuation of resultant assets and liabilities gives a true and fair view.
(2) Development
(a) Effect on risk
There is an increased inherent risk at the level of the account balance of deferred development
costs in that its valuation is subject to a considerable degree of uncertainty.
The auditors will need to obtain sufficient reliable evidence on the valuation of any amount
carried forward as deferred development cost in respect of project 21a at the year end. If the
project is not completed, the projected future costs to complete will need to be carefully
reviewed to ensure the expected total project cost is reliably estimated.
The forecast of revenues expected to be generated by the project will also need to be carefully
reviewed as will the viability of the product. If there are significant uncertainties it may be
necessary to seek the advice of an expert. If there is any doubt that future revenues will not
substantially exceed the total costs of the project, including costs to complete, the valuation of
deferred development costs must be written down if not written off completely.
(3) Bonus
(a) Effect on risk
A profit related bonus puts pressure on management to achieve a high profit. This increases
inherent risk at the entity level.
All account balances involving a substantial degree of management estimation will need to be
carefully reviewed. Provisions, such as for bad and doubtful debts and for inventory
obsolescence, are all likely to be reduced. Although individual reductions may be
unexceptional the auditor will need to consider the cumulative effect. There may even be
pressure to distort cut-off such as by holding open the sales journal or delaying the issue of
credit notes. The level of substantive testing in all such areas may need to be increased
relative to previous years.
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(4) Internal audit
(a) Effect on risk
The introduction of an internal audit function will improve the assessment of the control
environment. If risk assessments relating to the effectiveness of controls were affected by
concerns over the control environment, introduction of an internal audit function may enable
any control risk assessment to be reduced. Assessment of control risk over specific assertions
relating to transactions or balances may be further reduced depending on the specific tasks
assigned to internal audit.
In order to confirm the reduction in audit risk relating to control effectiveness, the audit plan
will need to include procedures for assessment of the adequacy of the internal audit function.
If internal audit is satisfactorily evaluated, it may prove possible to co-ordinate internal and
external audit activities to reduce the level of substantive procedures performed by the
external auditors. The audit plan will need to identify procedures to which this might apply
and to include procedures to evaluate the specific work of internal audit in those areas.
(5) Gearing ratio
(a) Effect on risk
The requirement to maintain the gearing ratio below a certain limit puts pressure on the
company which increases inherent risk at an entity level. Gearing has already risen
substantially for the year to date. Poor profit performance will reduce shareholders equity
and thus increase gearing even further.
If the gearing ratio rises above the agreed level, the loan may have to be repaid. The auditors
will need to pay special attention to the directors assessment of the companys future as a
going concern particularly if gearing rises and the loan has to be repaid.
Answer 17 PARKER
(a)
According to ISA 200 Objective and general principles governing an audit of financial
statements:
Audit risk
Audit risk is the risk of giving an inappropriate opinion on the financial statements; for
example failing to qualify when the financial statements contain a material error. Audit risk
has three individual components in the formula:
Audit Risk = Inherent Risk Control Risk Detection Risk
Inherent risk
This is the risk of an assertion to a misstatement that could be material, either individually or
when aggregated with other misstatements, assuming there are no related controls.
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Control risk
This is the risk that the internal control system will fail to prevent or detect a material error.
The auditors preliminary assessment of controls will help determine control risk.
Detection risk
This is the risk that the auditor will fail to detect a misstatement that exists in an assertion that
could be material. For a given level of audit risk, the acceptable level of detection risk bears
an inverse relationship to the assessment of the risk of material misstatement at the assertion
level.
(b)
(i) Audit risks
Over-trading
The turnover of Parker is growing quite rapidly, although this growth is not matched in net
profits. The company has been expanding into the Internet, and plans to introduce other
product lines for sale in this division. There is the risk that the business will exhaust any cash
reserves as it continues to expand but does not generate sufficient additional cash to pay for
that expansion. In this situation suppliers may go unpaid and at the extreme the business will
be forced into liquidation. Therefore the financial statements may not adequately disclose
doubts about going concern.
Internet trading
The decision to expand the Internet business may cause other problems for Parker. Selling of
books and CDs appear to be related as they are both forms of entertainment and the customer
knows what the product is like. Selling toys may fall into a similar category, but garden
furniture and clothes are different. Garden furniture is bulky and will certainly cost more to
deliver while clothes are sold more on taste and a high level of returns can be expected.
Specific risks with this decision therefore relate to:
The overall ability of management to run the business given their apparent lack of knowledge
of Internet trading.
The need to setup and manage systems for the sales of many new products.
The need to allow for a much larger volume of returns.
The possibility of inventory obsolescence if Parker overstocks on clothes which go

out of fashion.
Control environment
The whole environment in which the control systems should be operating appears weak.
There are errors in the systems, the extent of which are not known, and the directors and the
accountant do not appear to be inclined to attempt to remedy the situation. The skills of the
accountant may also be questioned because he appears to have been appointed not on merit,
but from some personal relationship with the directors. Other errors may also have occurred
which have not been detected. The risk is that the financial statements may have material
errors in them.
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Bank loan
The directors require additional finance to expand the business. To provide this finance it is
likely that the bank will require sight of the audited financial statements; the directors of
Parker expect the audit to be completed prior to meeting the bank. The auditor may need to
write to the bank to disclaim reliance on the audit report for the purposes of making a bank
loan. There is a risk to the audit firm of being sued if the bank relies on the report and sustains
financial loss. There is also a risk to Parker that the loan is not obtained and the company goes
into liquidation. The financial statements may need to be prepared on a breakup basis.
First year of audit
The audit is also risky for the audit firm because it is the first year of an audit and the client
has expectations about the type of auditors report to be produced. The accounting systems
also appear to be unreliable, again increasing the risk of material error. The audit firm must
ensure that sufficient time and resources are allocated to the audit to ensure that the audit
opinion can be supported. Pressure from the directors to complete the audit quickly will have
to be resisted.
(ii) Going concern work
Review the financial position of the company in detail. Budgets and cash flow forecasts
showing income and expenditure for at least the next 12 months must be reviewed. The
accuracy of these forecasts can be determined in part by checking how accurate past forecasts
were. If the directors have not produced this information, then the auditor will ask them to
produce it.
If not already done so, obtain a standard audit bank confirmation letter. Check the letter for
overdraft and loan facilities to ensure that they have not been exceeded. Also check review
dates (although it appears this will be three months after the end of the year) and confirm with
directors what accounting information will be expected at these dates.
Review correspondence with the bank for signs of strain with the bank. A poor relationship
implies that further loans may not be granted and alternative finance will be required.
However, it is unlikely that any details of the relationship with their client will be provided by
the bank.
Make enquiries with the directors regarding the availability of other finance which will be
necessary for the planned expansion. Obtain supporting evidence for this finance, such as
letters confirming amounts available and interest rates payable.
As close as possible to the date of the auditors report, review the most recent management
accounts to help determine the extent of any additional finance required.
Obtain a letter of representation from the directors confirming their responsibility for
preparing cash flow forecasts and for the overall going concern status of Parker.
Use all the evidence obtained to take a view on the going concern status of Parker and review
the adequacy of disclosure (if any) in the accounting policy note to the financial statements.
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Answer 18 CLEANCO
Risks Controls Tests of control
(a) Human Resources
There is a risk that staff without All staff should be required to The auditor should:
proper experience or training are fill in proper application forms
employed (and might cause and submit references with take a representative
damage to client property). them. References should be sample of staff from the
checked for all new staff payroll and inspect the
employed. To the extent relevant application forms
permitted by law, staff should to ensure that they have
be asked to provide details of been properly completed.
criminal convictions. All staff, References should also be
particularly those without inspected.
experience, should receive
proper training.
Inappropriate staff, such as Systems for allocating staff to for a sample of high risk
those with criminal convictions, assignments should ensure that clients, ensure that only
perhaps, might be employed in only appropriate staff are appropriately classified
high security environments. allocated to high risk clients staff have been utilised.
by means of a staff
classification system.
Staff might misappropriate There should be documentary take a sample of entries in

company or client property. controls over the movement of the documentation showing
cleaning materials and reviews movements of materials
of the usage of cleaning and ensure that appropriate
materials. entries in systems have
been made.
The company should ask clients review the overall usage of

regularly about the levels of cleaning materials and
satisfaction with the service investigate any unusual
provided (and have variations.
investigation and disciplinary
procedures in place where review the result of client
allegations of misappropriation satisfaction surveys and
are made). establish if appropriate
management responses
have been made.
There is a risk that staff are paid All normal payroll controls such for a representative sample
for hours not worked, or that as the use of timesheets, of entries in the payroll, re-
incorrect payroll deductions are reconciliations and regular perform calculations to
made. reviews of payroll costs should ensure that they are made
be in place. Personnel controls correctly, ensure that
should ensure that new staff can appropriate authorisation
only be entered onto the payroll has been made and review
system with appropriate the overall level of payroll
authorisation from an cost, investigating
independent official. variations.
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A high turnover of staff Staff should receive feedback on inspect the documentary
increases all of the risks noted their performance and be evidence of staff reviews,
above. rewarded for good performance review and assess the
and long service. processes by which good
performance and long
service are rewarded, and
for a sample of staff with
good reviews and/or long
service records, determine
whether rewards have been
forthcoming.
(b) Procurement
There is a risk of fictitious or Authorisation controls should The auditor should:

excessive payment to suppliers ensure that an appropriate,
review a representative
(i.e. fraudulent payments). independent official authorises
sample of suppliers on the
the acceptance of new suppliers
system and inspect written
onto the system and that only
evidence of authorisation
authorised suppliers can be
for them.
used.
There is a risk of inaccurate, Authorisation checks on analytically review the

delayed or incorrect payments. invoices should ensure that only level of payments for, and
goods that have been received utilisation of, goods on a
are paid for and that agreed periodic basis and
prices are being paid. investigate any significant
variations.
There is a risk that the company Controls over the purchase review a representative
does not obtain the best value ledger such as reconciliations sample of invoices, credit
for money by using existing with a purchase ledger control notes and other
suppliers. account and the matching of documentation (hard copy
documents should be in place to or electronic) for evidence
ensure that discounts are of matching to appropriate
obtained for timely payment and goods received
that good relations with documentation and price
suppliers are maintained. lists.
There should be regular, review and critically assess
documented negotiations with the documentation and
existing suppliers and regularity of negotiations
discussions with alternative and discussions.
suppliers to ensure that value for
money is being obtained.
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(c) Marketing
The third party advertiser may The contract between Cleanco The auditor should:
be in breach of advertising and the advertising company
review the contract with the
regulations. should require that all
company, and the
advertising is in accordance
advertising material to
The type of aggressive direct with regulations and any best
ensure that it is in
mail advertising may actually practice guidance (Cleanco
accordance with
damage the reputation of wishes to retain its high
regulations and any best
Cleanco which might result in a reputation). There should be
practice guidance. The
decrease in market share. clauses in the contract requiring
auditor should ensure that
the company to indemnify
appropriate legal advice
Cleanco against any costs
was taken with regard to
arising from such breaches.
indemnities and other
Cleanco should take legal
important elements in the
advice on the wording of such
contract.
clauses.
obtain documentary
The third party should be
evidence to show that the
required to submit all
advertising material has
advertising material to Cleanco
been approved at an
for approval, and Cleanco
appropriate level within
should have final control over
Cleanco.
the design and content of the
advertising material.
review budgets and
There is a risk of extensive There should be proper
management accounts to
marketing expenditure not budgeting for advertising costs,
ensure that advertising
resulting in new business. and a regular review of such
costs have been controlled
costs by comparison with new
and are resulting in an
business obtained.
appropriate level of
Cost controls should ensure that increased business at
discounts offered are not so appropriate prices.
great as to make contracts
unprofitable, after marketing
costs have been taken into
account.
NB: There are several other issues that might be dealt with in the answer to this quesion, for example
risks, controls and tests relating to health and safety procedures.
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Answer 19 BUSINESS RISK
(a) Risk classification
Risk classification is part of the overall risk management process that can be applied
to individual account areas as well as to the financial statements and to the business
as a whole.
Risk classification is part of risk assessment, which in turn is part of the overall risk
management process whereby the risks to the business of not achieving its
objectives are analysed, and split down into risks associated with the various
business or operational units according to the way the business is managed.
The classification of risk as high, medium or low, together with classification as to

whether a risk is, for example, probable, possible or remote (or high, medium
or low likelihood) permits the entity to allocate its resources to optimum effect.
Risks, once properly understood, can then be managed by means of, for example,
reduction, transference or acceptance. For example, a high risk of non-payment in a
receivables ledger can be reduced by implementing controls that reduce the risk
(such as performing credit checks and by regularly chasing overdue debts). The risk
might instead be transferred by factoring the debt. For low risks (such as the risk of
non-payment by a long-standing customer who always pays promptly) the risks may
be accepted.
(b) Classification of risks for receivables
(i) Small retail shoe shops
Despite the fact that individual accounts in this category have small balances, the category as
a whole is significant to Twinkletoes because of the total amounts owed (one third of total
receivables), the rising level of bad debts and the adverse effect of slow payers on cash flow.
It is likely that most of these accounts individually are low risk because customers pay
promptly and the amounts are small. Accounts that are significantly overdue may be classified
as medium risk, but probably only if they are substantial accounts because all entities must
expect to experience a small number of small bad debts. If however, a large number of
accounts are significantly overdue, they may be classified as high risk.
(ii) Large retail shoe shops
Some of these accounts are large and overdue and may therefore be classified as medium or
high risk. However, as the total value of such accounts is around 22% of total receivables and
the total value of the overdue accounts may be small in relation to total receivables, the
classification should probably only be medium risk. The classification for accounts that are
not overdue may be low risk.
Overseas accounts. Whilst these might at first appear to be at risk because the accounts are
being lost, they represent a small proportion of accounts by both number and value
(customers currently pay in advance). This means that they may be viewed as low risk.
(iii) Chains of shoe shops
As with the large shoe shops, large and overdue accounts might be classified as medium or
high risk. However, high street chains of well-established shops are less likely to become
insolvent than less well-established entities and therefore represent a lower risk. This means
that the classification may be low risk, even for accounts that are large and overdue.
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(iv) Mail order companies
New accounts generally represent an increased risk of bad debts and a large number of new
accounts increases this risk. However, there is no history of bad debts in this category at all so
the new accounts may therefore be classified as medium risk. Existing accounts within this
category may be classified as low risk because there is no history of bad debts.
(c) Internal controls
(i) All customers
I would recommend that:
credit checks be performed when new customers seek credit, and that cash in
advance or on delivery is required where large orders are placed by new customers;
credit limits be set for all customers based on the length of the relationship with the
customer, the volume of sales and their payment history;
payment terms be set (say, 30 days for local customers, 45 days for overseas
customers);
insurance be taken out against the risk of bad debts.
These controls will help ensure that accounts do not become overdue, damaging the
companys cash flow and increasing the risk of bad debts.
(ii) Slow paying customers
dedicated staff are assigned to chase slow payers regularly for outstanding amounts
and to ensure that a stop is put on accounts that are significantly overdue;
legal action is taken against those customers owing large amounts for long periods
for which there are no good reasons.
(iii) Larger accounts large shops, chains of shops and mail order companies
I would recommend that dedicated staff are assigned to manage the relationship
with larger customers, particularly the mail order companies.
(iv) Overseas customers
overseas customers be allowed a credit period of say, 45 days in order to permit the
required bank transfers to take place;
overseas customers be required to pay in the currency used by Twinkletoes (except

perhaps for large orders which may be backed by government guarantees) or in a
stable currency which does not fluctuate significantly against the currency used by
Twinkletoes.
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Answer 20 GRINDSBROOK CLOTHING COMPANY
(a) Factors to be taken into account in deciding whether to accept the assignment
The fact that I have considerable experience in this area is a good reason to accept
the assignment my skills and experience and my qualification may be valuable to
the company.
However, I have a continuing duty of confidentiality to my previous employer and I

must not disclose any information relating to my previous employer to my sister.
The fact that I am related to the companys owners will mean that my view may not
be sufficiently independent or objective, even though there may be no formal
requirement for me to be independent as I am not carrying out an audit or assurance
assignment. I may, for example, be subconsciously influenced or put under
pressure by my sister.
As there are some disagreements among family members the fact that I am the
managing directors wifes brother, it will be important for all of the family
involved in the management of the company to agree to my taking on this
assignment if it is to be effective.
I also need to consider my existing client commitments, I may be too busy to

perform this assignment effectively. I need to consider on what basis I will charge
the company for my services.
(b) Risks and actions to deal with them
External risks
The main business risk facing the company is competition from new entrants the companys
market share is declining. This share may decline further if the company does not have an
Internet presence and does not extend its marketing activities.
Dealing with the risk
Marketing is essential to any retail business and even if the companys products are high
quality, it will not be possible to sell them if they are not properly marketed. The company
should, for example, seek advice on setting up a web-site and should consider employing a
full-time marketing professional.
A further risk relates to the different views of family members the business appears to be
prevented from growing because of the attitude of the managing director.
It would be helpful if the family could be persuaded to agree on objectives and to develop a
plan to achieve them. If the business is to be passed on to junior members of the family, it
would be better for them to be involved in this process, including those individuals who are
not currently involved in the business.
Financial risks
The company may not be optimally funded, it is not very profitable and turnover is
growing slowly. This is related to the fact that the company is a family-owned
company that is structured according to family relationships.
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Additional investment could be obtained from family members to expand the

business, and additional bank financing could be used for the same objective. The
long-term bank loan in particular might be increased.
The company may wish to retain the family structure of management, however, it
may be in the best interests of both the family and the company in the long term for
plans to be made to pass more control to junior members of the family. This will
enable them to gain appropriate experience of the responsibilities involved in
running the business.
Operational risks
The company does not source its supplies effectively, which has an effect on the
budgeting process. It may also have an effect on the quality of products. The control
and budgeting process is further hampered by the fact that the company has not
employed a proper accountant and the fact that the systems are out of date and slow.
The company should consider employing an accountant. This would make it easier
to control and monitor costs and profitability. The company should also consider
investment in new systems, which would help with receivables and payables
management. All of this requires expenditure, but there appears to be scope for
increased funding, as noted above.
Compliance risks
The companys financial statements are of poor quality and late. There are often
penalties for the late filing of financial statements and although these may be
relatively small, the costs of correcting errors may be disproportionate to the
benefits.
The company should consider employing a professional accountant or ensure that

whoever is responsible for preparing the accounts and filing them is doing so
consistently and to an acceptable standard.
Answer 21 ANALYTICAL PROCEDURES AND MATERIALITY
(a) Possible reasons for changes
All of the changes noted below may also be due to simple accounting errors or, in some cases,
misappropriation of inventory or cash.
(i) Increase in current ratio
An increase in the current ratio may indicate increased inventory, cash or receivables levels.
The implications of this may be that the company is expanding, or alternatively that it is
experiencing trading difficulties and is unable to sell its inventory or to collect its receivables.
An increase may also be due to a decrease in trade payables or other current liabilities.
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(ii) Decrease in gross profit margin
A decrease in the gross profit margin may indicate that the cost of raw materials or bought-in
goods has increased, or that discounts or selling prices have decreased. This may not be a bad
thing if the reason for this is an overall increase in turnover.
(iii) Increase in inventory holding period
The inventory holding period indicates the number of days the company could continue to
trade if supplies were to cease. The longer the period, the higher the level of inventory held.
Inventory holding involves expenditure. Generally, the lower the figure the better provided
that the company does not run out of inventory.
An increase can indicate that the company is unable to sell its inventory. An increase can also
indicate that the company is expecting additional sales, or simply that the business is
expanding. Many businesses are cyclical and increases and decreases are to be expected.
(iv) Increase in dividend cover
Dividend cover shows how many times a company could pay the dividends it has decided to
pay to shareholders. If a companys dividend cover is increasing, it may simply mean that it is
making greater profits in relation to the dividends it pays out.
It may also mean that the company could pay out more dividends in future, or that the
company is paying out a reduced dividend and is investing more in the business.
(v) An increase in capital gearing (leverage)
Gearing is the relationship between equity and borrowings. A high level of gearing generally
indicates that the company must service (pay the interest on) fixed interest borrowings. This
means that there is less available for shareholders but it may also mean that the company is
expanding, which means greater returns for shareholders in the future. A high gearing ratio
may mean that the company is at risk of going concern problems.
(b) Materiality
(i) Concept
Information is material if its omission or misstatement could influence the economic

decisions of users taken on the basis of financial statements. Materiality depends on the size
of the item or error judged in the particular circumstances of its omission or misstatement. So
what might be material in one year might not be material the next, and what might be material
to one company might not be to another.
(ii) Audit work
The quantitative aspects of materiality are often, in practice, calculated as a

percentage of turnover, profit before tax or assets, or a particular class thereof.
Auditors calculate materiality for individual account areas, and for the financial
statements as a whole. They look at the aggregate (net) effects of misstatements and
omissions for the financial statements as a whole. Companies sometimes adjust the
accounting records and financial statements for immaterial items, sometimes they
do not.
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Materiality is related to risk and is used in the calculation of sample sizes and
tolerable error, and in the performance of analytical procedures. Less work is
performed in immaterial areas than in material areas, although some work is always
performed because an area that may appear to be immaterial may, when tested,
prove to be material.
(iii) Qualitative example
The disclosure of accounting policies is a qualitative aspect of materiality if

accounting policies are not adequately described in the financial statements, the
financial statements will not fairly present the position in all material respects, even
though the figures are correct.
The description of a matter as extraordinary when it is not is another example of a

matter that is material.
Answer 22 CONCEPT OF MATERIALITY
Concept
Financial statements are materially misstated when they contain errors or irregularities whose effect,
individually or in the aggregate, is important enough to prevent the statements from being fairly
presented. In this context, misstatements may result from misapplication of applicable Accounting
Standards, departures from fact, or omissions of necessary information.
ISA 320, Audit Materiality, requires auditors to consider materiality when determining the nature,
timing and extent of audit procedures. In complying with this requirement ISA 320 recommends that
auditors make preliminary judgements about materiality levels in planning the audit at the following
two levels:
the financial statement level (overall materiality), because the auditors opinion on fair
presentation extends to the financial statements taken as a whole;
the account balance level (testing materiality), because the auditors verify account balances in
reaching an overall conclusion that the financial statements are fairly presented.
The overall level of materiality and the nature of account balances enable auditors to determine which
account balances to audit and how to evaluate the effects of misstatements in financial information as a
whole. Materiality at the account balance level assists auditors in determining what items in a balance
(or transactions class) to audit and what audit procedures to undertake (eg whether to use sampling or
analytical procedures).
Overall financial statement level
There may be more than one level of materiality relating to the financial statements. For the statement
of comprehensive income, materiality could be related to revenue or to profit (usually before tax). For
the statement of financial position, materiality could be based on shareholders equity, assets or liability
class totals.
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In making a preliminary judgement about materiality, auditors initially determine the aggregate level of
materiality for each financial statement. For example, it may be estimated that errors totalling $100,000
for the statement of comprehensive income and $200,000 for the statement of financial position would
be material. For planning purposes, the auditors should use the smallest aggregate level of
misstatement considered to be material to any one of the financial statements. This decision rule is
appropriate because the financial statements are interrelated and many audit procedures pertain to more
than one statement. For instance, the audit procedure to determine whether year-end credit sales are
recorded in the proper period provides evidence about both accounts receivable (statement of financial
position) and sales (statement of comprehensive income).
ISA 320 offers no guidance for determining this relationship but, where an item has an effect on profit,
a widely used rule of thumb states that:
an amount which is equal to or greater than 10% of profit is presumed to be material;
an amount which is equal to or less than 5% of profit may be presumed not to be material;
to determine whether an amount between 5% and 10% is material is a matter of judgement.
Other commonly used bases, and materiality thresholds expressed as a percentage of that base, are as
follows.
Base Materiality threshold (%)

Sales 05
Gross profit 20
Total assets 05
Equity 10
Qualitative considerations
The emphasis in planning materiality is on quantitative considerations. ISA 320 acknowledges that in
designing the audit plan, the auditor establishes an acceptable materiality level so as to detect
quantitatively material misstatements. Since the errors are not yet known, their qualitative effect can be
considered only during the testing phase of the audit, as evidence becomes available.
Qualitative considerations relate to the causes of misstatements or to misstatements that do not have a
quantifiable effect. A misstatement that is quantitatively immaterial may be qualitatively material.
This may occur, for instance, when the misstatement is attributable to an irregularity or an illegal act by
the entity. Discovery of either occurrence might cause the auditors to conclude there is a significant
risk of additional similar misstatements. Although it is suggested that the auditors should be alert for
misstatements that could be qualitatively material, it ordinarily is not practical to design procedures to
detect them.
Account balance/class of transactions level
Account balance materiality is the minimum misstatement that can exist in an account balance for it to
be considered materially misstated. In making judgements about materiality at the account balance
level, the auditors must consider the relationship between it and financial statement materiality. This
consideration should lead the auditors to plan the audit to detect misstatements that may be immaterial
individually but that may be material to the financial statements taken as a whole when aggregated with
misstatements in other account balances.
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When the auditors preliminary judgements about financial statement materiality are quantified, a
preliminary estimate of materiality for each account may be obtained by allocating financial statement
materiality to the individual accounts. The allocation may be made to both statement of financial
position and statement of comprehensive income accounts. However, because most statement of
comprehensive income misstatements also affect the statement of financial position and because there
are fewer statement of financial position accounts, many auditors make the allocation on the basis of the
statement of financial position accounts. Allocating overall materiality to accounts is heavily
dependent on the subjective judgement of the auditors. The auditors judgement may be influenced by
qualitative considerations. Materiality in auditing cash balances may be set at a much lower level than
materiality in auditing intangible assets. Cash is known to be capable of precise determination and is
critical to the liquidity of the entity. Intangible assets, on the other hand, are known to be incapable of
precise valuation and users are unlikely to be misled by a relatively large misstatement in the reported
amount.
Answer 23 LENTON TEXTILES
(a) Cash sales system
(i) Weaknesses
Sales invoices need to be sequentially numbered (if they are not pre-numbered, they
should be, to ensure there are no missing items).
When the dispatch department give the customer the goods there is no control to
ensure he pays for them. He should not be given the goods until he returns with an
invoice which has been receipted by the cashier.
The sales invoice should not be raised by the cashier, as he could perpetrate a fraud
by issuing a full-cost invoice and getting the cash from the customer. Subsequently,
he could issue a lower value invoice, destroy the original invoice and
misappropriate the difference.
As the cashier raises the sales invoice there is no control to correct any errors he
makes. Also, he may not use the correct prices when preparing the sales invoice (as
he may not have an up-to-date price list).
There is no control to ensure that the cashier banks the cash for each sales invoice.
Another member of staff should check this is happening.
There would be a significant improvement in the controls in the system if the sales
department raised the sales invoice (rather than the cashier), and, as stated above,
the customer was not allowed to collect the goods until he had paid for them. As a
further control, the sales department could post the sales invoice to a sundry sales
account in the sales ledger, and the cashier could post the cash. The balance on this
account would show invoices raised where no cash has been received, and they
should be investigated.
(ii) Systems-based tests
Record the system and perform a walk-through test to confirm the flowchart is
correct.
Evaluate the controls and note the weaknesses (as described in part (i) above).
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Test the system by starting from a sample of advice notes raised by the sales
department. These advice notes should be sequentially numbered. I would check a
sample of advice notes (eg four sets of 50 sequentially numbered advice notes
spread throughout the year) and investigate any that are missing from the sequence.
For a smaller sample of advice notes check that:
a copy is in the dispatch department;
there is evidence of the goods being dispatched (either by a change in the

inventory records or acknowledgement by the storekeeper on the advice
note); and
the customer has signed for the goods.
I would follow through to the cashier and check that:
he has raised a sales invoice and that its value has been recorded in the
cash book;
the sales invoice is sequentially numbered (if it is not, I would note the
fact in my management letter);
the sales invoice refers to the advice note, that the details agree with the
advice note; that the prices per unit are correct and the calculations on the
invoice are correct.
For a large sample of advice notes, I would check that a sales invoice has been
raised and the cash has been entered in the cash book. I would investigate cases
where there is an advice note and no cash has been banked for this sale.
I would check the bank reconciliation to ensure that these cash sales are banked
promptly (or I could check that the most recent cash sales have been banked
promptly).
Based on this work, I would decide whether the system is operating accurately.
There are many serious weaknesses in the system, as noted in part (i) above, and
these would be reported in my management letter, together with any problems I
have found in my tests. If I find a lot of problems, I would check more items and I
would report them to the chief accountant, financial director or managing director.
(b) Mail opening
(i) Why two people
Opening mail involves custody of the asset (eg cheques) and recording the transaction (ie
recording cash received). If opening of the mail was carried out by a single person, there
would be no division of duties between these two transactions, so there would be a weakness
in the system of internal control which could allow a fraud to take place (or an error to be
undetected). By having two people open the mail, one checks the work of the other (ie a
system of internal check), and provided there is no collusion, this should prevent fraud and
error taking place. Ideally, neither of these two people should be the cashier.
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(ii) Audit work from mail opening to banking of cheques
Attend the opening of the mail as a surprise. Two people, independent of the
cashier and sales accounting department should open the mail. The cheques
received should be listed and the total calculated. A copy of the list and the cheques
should be handed to the cashier, and the second copy of the list should be filed
(separately from the cashier).
Obtain a copy of this list and check that the cheques are entered in the cash book
and subsequently banked by the cashier.
There should be evidence that a responsible official periodically test checks the lists
of cheques received to the cash book.
The total of the cash received for the day as recorded in the cash book should be
entered on the paying-in slip, and the paying-in slip should be stamped by the bank
on the same day or the day after the cheques have been received.
Check to the bank statement that daily sums have been credited to the bank
statement on either the same day as the cheques were paid in or shortly afterwards
(ie within two banking days).
Check a further sample of days cash received, starting from the list of cheques
received to the entry in the cash book and the date stamped by the bank on the
paying-in slip. This sample would be spread throughout the companys year. A
check of the bank reconciliation at a recent month end should ensure that no
teeming and lading fraud is taking place (ie cash received on the last day of the
month should be credited by the bank within two or three banking days).
(c) Credit notes
(i) Why credit notes are issued
When the goods are returned.
When there is a short delivery (all the goods on the invoice are not received by
the customer). Credit is given for the goods not delivered.
When the invoice charges the goods at too high a price. Credit is given for the
difference.
Any other errors on the sales invoice (eg incorrect sales tax charged, or computation
errors)
Where the goods are faulty. Sometimes this may result in the goods being returned,
but in other cases an allowance may be given to compensate the customer for the
goods not being perfect.
Additional charges made on the invoice which should not have been made or are
more than agreed (eg charges for carriage when there should be no carriage charge).
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(ii) Checking that credit notes have been issued for valid reasons
Ascertain and record the system. I would expect all credit notes to be authorised as
prescribed. There should be sufficient controls in the system to prevent fraudulent
or unauthorised credit notes from being issued;
Select a sample of credit notes from a number of places in the system. The credit
notes should cover the companys financial year and a greater proportion of large
value credit notes would be checked. The credit notes would be selected from:
The sales ledger (with a computerised sales ledger this would be from
entries on customers statements);
The note acknowledging return of goods by the customer, which is raised

by the department receiving these goods (it may be the dispatch
department). This check would ensure that credit is given for all goods
returned;
A sample of credit notes which are filed in sequential number order;
A sample of credit notes listed in the sales day book.
For all these credit notes, I would check that they have been authorised by an appropriate
responsible official as prescribed. For the return of goods, I would follow through from the
goods returned note to the credit note and check that the quantities on the credit note agree
with the goods returned, and the price per unit agrees with the original sales invoice (or is less
than the sales invoice figure if the customer returns the goods damaged). I would note any
returns of goods where no credit note has been issued (as a provision should be included in
the accounts if the credit note has not been issued before the year end). Also, if there is a
long delay between the return of goods and issue of the credit note, there could be cut-off
errors at the year end (this point would be included in the audit working papers for
consideration at the final audit).
For most of the other items, I would check the companys records of correspondence with the
customer. Ideally, there should be a letter from the customer as this would provide good
audit evidence. If there are only written notes by the companys staff, this is weaker evidence
and it could be fraudulent (eg the company could raise a credit note for a valid debt, and an
employee misappropriate cash received from the customer). This evidence would be more
reliable if it comes from more than one member of the companys staff (eg a member of the
sales staff and the credit controller).
Evidence expected
Where there is a short delivery, there should be a letter from the customer and
evidence that not all the goods were received. The inventory records may indicate
that not all the goods were sent, and a claim should be made against the carrier if
that company has lost some of the goods;
Where the charge is at too high a price, I would check the correct price to the
companys authorised price list;
Where there is an error on the invoice, I would inspect it and consider whether it is
reasonable;
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Where the goods are faulty, there should be a letter from the customer; and there
may be a report from an employee of Lenton Textiles which confirms that the
goods are faulty or damaged;
Where there are unauthorised charges on the invoice, I would check that they should
not have been made.
Based on this work I would assess the strengths of the system for issuing credit notes. I
would report any weaknesses to management.
Answer 24 BESTWOOD ENGINEERING
(a) Purchase and receipt of goods
Tutorial note: The question specifically refers to controls to be exercised in the purchasing
department.
For all goods ordered, there should be a purchase requisition from a user
department. The purchasing department should not be permitted to raise purchase
requisitions; as this would create a weakness in the division of duties. For goods
required by the purchasing department, they should request another department (eg
the accounts department) to raise a purchase requisition. Before raising the
purchase requisition, the accounts department should ensure it is for goods the
purchasing department require and are authorised to order.
The purchasing department should check the purchase requisition is for goods the
user department is authorised to buy or consume. If the value of the order is
substantial, the purchasing department should ensure there is a need for such a large
order, by checking current inventory levels and future orders to determine whether
so large a quantity or value is required.
The purchase requisition should use a standard form and be signed by an authorised
signatory.
The purchasing department should order the goods from an authorised vendor.
Where there is a choice of vendor or a new vendor is required, the purchasing
department should obtain the product from the vendor who provides the product or
service at the best price, quality and delivery. For audit purposes, it is desirable for
staff in the purchasing department to record details of the vendors contacted, the
price, delivery date and perceived quality, and the decision on which vendor was
finally chosen.
The purchasing department should raise the purchase order which should be signed
by the purchasing manager. For large value purchases, a director may be required
to sign the purchase order. The purchase order should be sent to the vendor, the
goods received department, the user department and the accounts department.
The purchasing department should ensure the goods are received on time. This may
require them to contact the vendor a week before the expected delivery date to
ensure they are received on time, and allow action to be taken if the delivery date is
later than specified on the purchase order.
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When the goods, are received, the purchasing department should receive a copy of
the goods received note (GRN) from the goods received department. They should
record the goods received against the order. From this information, they will be
able to take action when there are short deliveries or the goods are received late.
Frequently purchasing departments file purchase orders in three types of file:
none of the goods have been received;

some of the goods ordered have been received;
all the goods ordered have been received (ie dead purchase orders).
The purchasing department may be part of the system which authorises purchase
invoices. They should check the goods on the invoice are consistent with the
purchase order and the price per unit is correct.
The purchasing department should be informed about short deliveries (ie the
quantity of goods received is less than on the purchase order or advice note) and
when there are quality problems. From this information, they can contact the
vendor so that corrective action is taken. Also, such details may be helpful in
determining whether the vendor should be used for future orders
The purchasing department should be informed of situations when goods or services

are received but no purchase order has been raised. With this information, the
purchasing department should contact the offending department and ensure that in
future a purchase order is raised for all the goods they order. The vendor should be
contacted and informed that an authorised purchase order must be received by them
(the vendor) before any goods or services are provided by the vendor.
(b) Authorisation of purchase invoices
Tutorial note: The question calls for control procedures in the accounts department before
the purchase invoice is processed.
The accounts department will receive the purchase invoice, which they should
record in a register.
The invoice expense will be included on the invoice (for posting to the general
ledger). The expense analysis will be checked by an independent department (eg
the purchasing or user department).
The accounts department will either match the purchase invoice to the goods
received note and delivery note or ask the goods received department to check and
authorise the purchase invoice.
the purchasing department will be asked to confirm the goods are as described on
the purchase order and the price per unit is correct.
The user department may be asked to authorise the purchase invoice.
An appropriate responsible official will be asked to authorise the purchase invoice.
Provided these checks are satisfactory, the accounts department should input the
invoice details into the computer which will post it to the accounts payable ledger
and the general ledger.
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Where there is a problem with the invoice (eg concerning the quantity, quality or price of the
goods received) the accounts department should put the invoice in a hold file. They should
contact the vendor (sometimes with the help of the purchasing or user department) and try to
resolve the problem. When either a credit note is received or the correct quantity and quality
of goods have been received, the accounts department will get authorisation (eg from the
purchasing department) that the situation is resolved and they should input the purchase
invoice into the computer (and credit note if this is required).
Periodically, an independent person should check vendors statements against the balances on
the accounts payable ledger. Differences between these two balances should be recorded. If
the transaction which created the difference is close to the date of the check, it is probable that
no action will be taken. However older items should be investigated to ensure that action is
being taken to resolve the problem.
(c) Controls over purchase of services
Frequently, procedures over receiving services are less strong and less effective than those
over receiving goods.
For some types of service there may be no system for raising purchase orders (eg electricity,
gas, water and telephone charges). However there should be a system for reviewing these
costs, by comparing them with the previous year (or period), with budget and with amounts
charged by alternative vendors. In this way, the company can ensure these services are
received at the most economical cost. For some of these services it may be possible to
suggest ways in which these costs can be reduced (eg by turning off lights and reducing the
temperature settings in winter). Costs of gas, electricity and water can be monitored by
checking the meter readings monthly and determining whether the consumption is reasonable.
For telephone expenses, the system should provide information on the cost for each
department, and each department manager should review his departments costs. A risk with
telephone systems is that they can be abused by staff, who make personal telephone calls
using the companys telephone system. The department managers should be made
responsible for checking this abuse is kept to a minimum.
For receipt of all other services, before the service is obtained, a purchase requisition should
be raised by the user department, and the purchasing department should raise a purchase
order. In emergency situations, it may be acceptable to raise a purchase requisition and order
after the service has been received (eg the repair of a vehicle which has broken down). There
should be a system whereby action is taken when no purchase order has been raised for a
service which has been received. In many situations when a service has been received, it is
probably appropriate that the department receiving the service should issue a goods received
note and send it to the purchases accounts and the purchasing departments. In this way, the
same system can be used for processing receipt of services as for receipt of goods.
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Answer 25 SMALL FIRM INTERNAL CONTROLS
Internal controls
Controls contributing to the orderly and efficient running of the business, safeguarding the
assets and adherence to management policies would include the following:
physical controls over access to the assets such as the locking of doors and the
maintenance of an appropriate fire and flood resistant environment;
insurance against disaster and contingency plans;
the use of passwords for access to computers and plant and equipment;
the numerical or other tagging of all equipment, referenced to an asset register;
performing periodic asset audits;
internal regulations requiring staff who take equipment such as laptops and motor
vehicles home to ensure that they are secure, and prohibiting staff from using their
own software on company equipment;
the maintenance of firewalls and virus checking software.
Controls contributing to the prevention of fraud and error, and the completeness and accuracy
of the accounting records would include the following;
the preparation and monitoring of capital expenditure budgets together with

authorisation of capital expenditure, disposals and depreciation rates by independent
persons at an appropriate level within the organisation who do not have day-to-day
responsibility for the related records or assets;
the maintenance of an asset register that is reconciled to the general ledger and the
assets themselves;
the periodic checking and review of asset lives, and fully depreciated assets, to
ensure that assets are being depreciated correctly, over an appropriate period of
time.
Answer 26 COTSGROVE DISTRIBUTORS
(a) Controls over dispatch of goods (to authorised customers)
The sales department should have received an order from the customer. Ideally this
should be in writing but telephone orders may be accepted from customers. For
telephone orders, the employee in the sales department should record the date and
time the order is received and its details.
Ideally, the company should send a sales order to the customer, which gives details
of the goods ordered; the price per unit, the date the order will be dispatched and
credit terms. The sales manager end credit controller should authorise this sales
order. It may be acceptable to by-pass the credit controllers authorisation if the
customer is on a list of customers authorised by the credit controller. This list
should be updated periodically with new customers. Some existing customers may
be put on stop if they become a credit risk.
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Before the goods are dispatched, they should be authorised by the credit controller.
As the company uses a computerised accounts receivable system the computer may
accept dispatches of goods to good credit risk companies (where the credit limit is
not exceeded) without the authorisation of the credit controller. In this situation the
credit controller will authorise dispatch of goods to poor credit risk companies and
those where the credit limit is being exceeded. With this system, the credit
controller should ensure that the standing data file of good credit risk companies
and customers credit limits are kept up to date.
The goods should only be dispatched to customers when the dispatch department
receives an authorised shipping document.
The dispatch department should get the carrier or customer to sign a copy of the
shipping document when they take the goods, as this is evidence that the customer
(or carrier) has received the goods (in cases where there is a dispute over a
delivery). This copy of the shipping document should be filed in the dispatch
department.
The computerised accounts receivable system should produce a sales invoice when
the goods are dispatched. The prices on the sales invoice should agree with the
sales order (or the companys authorised price list) and it should be posted to the
accounts receivable ledger.
There should be periodic inventory counts to check that the quantities of inventory
are the same as those shown by the physical inventory records. Any differences
should be investigated. This check should either prevent or detect any unauthorised
dispatches of goods (or misappropriation of goods).
A person independent of the dispatch, sales and accounts receivable accounting

department should check that:
a sales invoice is issued for every dispatch of goods;

all customer orders are satisfied within a reasonable time
This person should check any cases of a dispatch of goods with no invoice and any
old orders where no goods have been sent to the customer.
An independent responsible official (eg the chief accountant) should periodically

check the gross profit margin on sales. This should highlight any cases of
customers being charged the incorrect price. Also, it will highlight
misappropriation of inventory and goods being dispatched without an invoice being
raised (these will also be highlighted by earlier checks).
The following duties should be carried out by different staff:
Authorisation of the customer order, and raising the shipping document

Credit control checks
Dispatch of goods to the customer
Processing of sales invoice.
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(b) Prompt receipt of cash
There should be a procedure for investigating the credit worthiness of customers.

For new customers the company may ask for recent financial statements of the
customer, bank and other customer references. Also, a credit rating agency could be
used to obtain an independent assessment of the customers credit risk.
For poor credit risk customers the company should require payment in advance or
cash on delivery.
Initially, the credit limit of a new customer will be based on its reputation and other
information obtained. For a large and financially stable company (eg IBM) a high
credit limit will be allowed, but for small companies and those with liquidity
problems, the initial credit limit should be small.
The credit limit of existing customers should be reviewed periodically. It will be

increased if the company pays its account promptly and sales are increasing. For
slow payers the credit limit may be reduced; or credit may be withdrawn.
The credit controller should put accounts on stop where the account is over the
credit limit or in arrears. Further dispatches should only be permitted with the
authorisation of the credit controller.
The company should have a procedure of chasing debts. They should send
monthly statements to customers, and regularly telephone customers where a
payment is expected or is in arrears.
There should be a procedure for following up old debts. This should start with the
customer being sent a reminder, then dispatch of goods should be stopped, legal
action should be threatened and finally the debt should be dealt with by a debt
collection agency or by a lawyer.
When cash is received in the post it should be opened by two individuals, who
should prepare a prelist of cash received. Any uncrossed cheques should be
restrictively crossed so that they can only be paid into the companys bank account.
Two employees should open the mail in order to prevent a weakness in the system
of internal control (ie they have custody of the cheques and are recording the
transaction). The cheques and remittance advices should be passed to the cashier
who will record them in the cash records and pay them into the bank. Finally, these
cheques should be recorded on the accounts receivable ledger. Periodically, an
independent person should check the pre-list of cash received to the cash records to
ensure all items are entered in the cash records and banked.
An independent person (eg the chief accountant) should check the bank
reconciliation and ensure that cash received is banked promptly, as late banking of
this cash could indicate that a teeming and lading fraud is taking place.
An accounts receivable control account should be maintained by a person

independent of the accounts receivable department and cashier. Ideally, the totals
posted to this control account should be derived from sources independent of the
accounts receivable department. However, in computerised systems the only source
of sales may be from the sales journal (which is not an independent source).
Nevertheless, the cash posted to the control account should come from the cash
records. The independent person (eg the chief accountant) should check the posting
of the accounts receivable control account and that the balance either agrees (or can
be reconciled) to the total of the balances on the accounts receivable ledger.
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Answer 27 DINKO
(a) (i) Internal control objectives
Control objectives include policies and procedures designed by management to:
Achieve the orderly and efficient running of the business including adherence to
internal policies this would include the regular, accurate processing and recording
of payroll payments.
Safeguard assets this would include the physical safeguarding of cash and
safeguarding money held in bank accounts by means of other controls.
Prevent and detect fraud and error fraud and error would include incorrect
payments or deductions from the payroll and payments of incorrect amounts for tax
and social insurance, payments for work not performed and payments to dummy
employees, for example.
Achieve accuracy and completeness of the accounting records and timely

preparation of reliable financial information; this would include making correct
payments and deductions from the payroll, correct payments for tax and social
insurance, and making payments for work performed only (not to dummy
employees, for example), in order that quarterly or half-yearly accounts can be
prepared (possibly), but in any case in order that annual accounts can be prepared
within the time limits for small companies.
(ii) Internal control environment and control procedures
The control environment relates to:
Managements overall style in encouraging awareness of the need for good controls,
for example.
The existence of organisational controls such as review of the payroll by an

independent person such as the managing director, and the rotation of payroll duties
amongst staff responsible for processing it this helps achieve all of the objectives
set out above.
Segregation of duties and supervisory controls to avoid the misappropriation of cash

(or allegations thereof) and to avoid fraudulent collusion to create, for example,
dummy employees or to make inflated payments this prevents the loss of assets
and/or inaccurate records.
Internal control procedures include:
Limiting direct physical access to the cash, such as the use of a security firm to
deliver cash, locking doors to areas where cash is held, keeping cash in a fire-proof
safe and the protection of the computer by password controls this will help
safeguard assets and ensure the completeness and accuracy of the records and
financial statements.
Controls over computerised applications, checking the arithmetical accuracy of

documents and the maintenance of control accounts this can be achieved by, for
example, the use of timesheets or clockcards, the use of reliable software with
programmed controls for the calculation of deductions, and the use of batch and
hash totals for information that is input into the computer system this helps
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achieve the orderly and efficient running of the business and the accuracy and
completeness of records and financial statements.
Approval and control of documents, such as the authorisation of the payroll itself,
and authorisation for the bank to make transfers and to deliver cash.
(b) Audit objectives, tests of control and substantive procedures
Objectives Tests of control and substantive procedures
Existence: of assets and Testing controls over the security of cash to ensure that they
liabilities such as cash on are operating effectively throughout the relevant period.
hand and in the bank, and of
Performing cash counts, with reconciliations to the records
the liability to pay staff and
and observing cash payments to staff, ensuring that
the associated tax and social
appropriate signatures are obtained and that unclaimed cash
insurance liabilities.
is promptly re-banked, for example.
Making checks on the physical existence of staff to ensure
that the related expenses and liabilities are genuine.
Checking after date payments to staff and for tax and social
insurance contributions.
Occurrence: payroll Performing cut-off tests to ensure that payroll costs incurred
transactions occurred during during the period have been recorded during the period by
the relevant accounting examining entries in the payroll records just before and just
period. after the period-end and checking back to source
documentation, such as timesheets or clock cards.
Completeness: there are no Performing starters and leavers tests to ensure that staff are
unrecorded assets or liabilities not paid before they join the company and are not paid after
(such as those noted under they leave this involves checking the payroll for two
existence, above) or separate periods and examining entries relating to starters
transactions (such as payroll and leavers in the intervening period.
payments) or undisclosed
Manually checking the accuracy of payroll calculations to
items (such as unrecorded
ensure that correct payments and deductions are being made
payroll liabilities).
in accordance with approved pay rates and approved
deduction rates for tax and social insurance.
Reviewing evidence of authorisation controls to ensure that
the payroll has already been checked.
Measurement: transactions As for completeness, above, and checking to ensure that the
such as payroll payments are payroll has been properly authorised and reviewed.
recorded at the correct
Checking entries relating to hours or time worked in the
amounts and are recorded in
payroll to source documentation.
the correct period.
Presentation and disclosure: Reviewing the financial statements with the aid of a
an item is disclosed and disclosure checklist to ensure that disclosure requirements
described in accordance with have been met.
accounting standards and
Reviewing the overall presentation of payroll transactions
legislation.
and balances.
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Answer 28 ASG
(a) Control objectives
Ordering of goods
Goods are only supplied to authorised customers

Orders are recorded correctly regarding price, quantity, item and customer details
Despatch and invoicing of goods
Orders are despatched to the correct customer

All despatches are correctly recorded
Despatches only relate to goods ordered and paid for by customers
Invoices raised relate to goods supplied by the company
(b) Audit tests on sales and despatch system
Audit test Reason for test
Using test data if necessary, access ASGs Ensure that order details are completely and
website site and input order details for accurately recorded by the website software.
specific goods. Trace those order details to
the orders pending file. Ensure that details recorded agree to those
input.
For a sample of items in the orders pending To ensure that details from the website
file, software are completely and accurately
transferred to the orders awaiting despatch
agree to the orders awaiting despatch
file.
file, ensuring that appliance details and
quantities are the same.
agree sales details for that customer to
To confirm that amounts are received for
the monthly reimbursement from the
each appliance sold, and therefore that
credit card company, checking amount
monies received are complete and accurate.
received is the product price less the
appropriate commission charged by the
credit card company.
agree the sales amount to the sales
To confirm that the amount of sales is not
ledger file.
understated or overstated in the ledger,
general ledger or financial statements.
Review goods awaiting despatch file for old To ensure that reasons for orders not being
items and inquire as to why those items are processed are being obtained. A large
still on file. number of old items may also indicate
problems with the credit card authorisation
systems which again will need to be
investigated.
For a sample of days, cast the sales day book To check the numerical accuracy of the day
file and agree the total sales to the general book and the accuracy of posting to the
ledger accounts for that day. general ledger file.
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For a sample of items in the goods awaiting To confirm that order details are completely
despatch file, agree to the despatch and accurately transferred to the despatch
information held on the despatch department department.
computer.
For a sample of items on the despatch To ensure that the despatch information is
department computer, accurate and that the despatch record itself
relates to a valid sale.
agree back to the goods awaiting
despatch file ensuring details of product,
quantity and customer agree.
agree to the inventory records
Ensures that the inventory system correctly
confirming that the correct appliance
records the appliance ordered and that the
record was updated.
inventory system remains accurate.
check customer signature is on file
To confirm that evidence is available for
agreeing receipt of goods.
receipt of goods confirming that goods have
been delivered.
For a sample of items on the despatch To ensure that goods have been received and
department computer, review to see that that procedures for investigating non-
evidence of delivery to customer is available. despatch or receipt are working.
Investigate records where no delivery
information is available obtaining reasons for
this.
Review the despatch department computer To ensure that the despatch process is
files for items not flagged order complete. working correctly and that incomplete items
Investigate and obtain reasons for these are being investigated.
items.
Note to candidates: The focus of the answer should be on substantive tests. Compliance tests
are allowable where they relate to the system described.
Answer 29 MILDRAIN
(a) Potential problems of unrestricted Internet access
Many companies are now offering services on the Internet. These services include limited
banking facilities, loan advice, tax advice, share dealing and advertisement of company
products. It is possible to buy and sell goods via the Internet. Thus an unauthorised official
with access to the Internet could notionally:
pay for goods of a personal nature by using a corporate credit card number;
sell the companys assets;
buy goods/services on behalf of the company;
disseminate confidential information (eg financial data);
give advice to customers which may prove to be negligent. The common practice
of putting a disclaimer at the bottom of public messages is not a fail safe shield in
this matter.
1068
Obviously these possibilities are always likely in a company but the Internet gives staff more
opportunity to carry out these acts. Thus an unauthorised official could cause significant
disruption in the companys operations by gaining access to the Internet. The question as to
whether the contracts made via the Internet in this fashion are legally binding is a separate
question depending upon the circumstances of the case. However, it can be seen that access
controls are essential to prevent problems being created by unauthorised access to this
powerful medium.
(b) Controls to prevent unauthorised Internet access
There are several controls which a company could use to prevent unauthorised access to the
Internet system. Identity recognition procedures can restrict access to the system. Access
may require the use of passwords, identity tokens or other security devices. Access controls
will involve the use of a card, badge or key system, personal identification numbers (PINS) or
a combination of these methods. These systems, however, control access and not the
personnel. It is possible to gain unauthorised access to the system by using an authorised
persons identity recognition device. Care must be taken to ensure that the system for issuing
badges, keys, tokens or PINs is secure.
Systems may also operate by voice reference, fingerprint recognition, signature or other
personal characteristics. Additionally it is normal for passwords to be encrypted in order to
prevent unauthorised use of the password.
A physical control could be the removal of the relevant hard disk from the computer
hardware. This would obviously prevent the user from gaining access to the Internet. Thus it
can be seen from the above that it is important that the entry points to the system are shielded
and protected.
Additionally procedural controls can be set up whereby information/transactions to be

processed by the Internet are only dealt with by authorised personnel. Essentially there would
be segregation of duties between the user department and the data input/output section. Also
the company could set up a formal fraud/error control project. In a risk based analysis of the
areas of corporate operations which are most at risk, the Internet system would obviously
come under close scrutiny.
(c) Validity of audit evidence
Audit evidence assists auditors in their judgements concerning the relevance and reliability of
the accounting assertions. It is the means by which the auditor achieves assurance about the
reporting quality and is the basis for the auditors opinion: Evidence should be valid and
relevant.
ISA 500 Audit Evidence states that the reliability of audit evidence can be judged by using
certain criteria, as follows:
external evidence is more reliable than internal evidence;

evidence from the companys records is more reliable when internal controls are
satisfactory;
evidence obtained by the auditors is more reliable than that obtained from the entity;
written evidence is more reliable than oral representations
1069
Evidence collected from the Internet system could be valid audit evidence but the quality may
vary. For example, a customer could confirm a balance outstanding via the Internet using the
customers ID. This could be construed as good audit evidence if there is no possibility for
example of altering the customers reply. Again if the procedural controls over access to the
Internet are good then the quality of the audit evidence derived from it is enhanced.
The auditor may set up his own access code on the Internet and test the information set up by
the client on the Internet system. This audit evidence will then have some validity depending
upon the quality of the clients initial input to the Internet system.
For example if property loan quotations are made by the company via the Internet, the auditor
could select a sample of these quotes as the base documents for his compliance tests.
Evidence generated by the Internet can be printed out by the client and thus is in documentary
form but the quality of the evidence will be determined by the validity of the source of the
information.
(d) Additional work on audit exceptions
Credit notes
A formal letter should be written to this supplier together with a detailed statement setting out
the make-up of the outstanding balance in the clients records. The letter should ask for
confirmation of the outstanding balance and/or a reconciliation of any difference between the
amount in the suppliers records and that in the clients records. The reply should be sent
directly to the auditors offices. Additionally the whole payables ledger should be scrutinised
to see if there are any similar cases. If the auditor is suspicious then a suppliers circularisation
should be performed and purchases cut-off further scrutinised and tests extended. Also the
credit notes could be traced to specific purchase transactions/invoices and the truthfulness of
the proposition that these were issued for overcharging can be examined.
The existing audit evidence can be further reviewed by looking at the Internet address from
which the credit notes had been issued. The company should have a list of addresses of
company suppliers and the source of the credit notes can be agreed to this listing.
Insurance policies and property loans
A sample of the new clients who had taken out insurance policies and loans could be taken
and direct confirmation techniques used to verify the authenticity of the transaction.
Additionally the auditor could write to the insurance company or loan company stating the
amount of the outstanding balance due to the client company and asking for direct
confirmation of the balance outstanding to be sent to the auditor.
Again the auditor could look at the source address on the Internet for these transactions and
try and determine the independent nature or otherwise of the audit evidence. Again the
auditor could scrutinise this evidence for any related party involvement.
(e) Resolving differences of opinion
Differences of opinion between members of an audit team are quite common because of the
subjective nature of many of the judgements made by auditors. The matter should be resolved
by open discussion between the members of the audit team and the audit senior should take
responsibility for any decisions made. Audit assistants are often reluctant to express an
opinion for fear of the effect it may have on their career. However, if the audit assistant is
convinced that material error could occur there is an ethical obligation to bring this to the
attention of the audit manager. The audit assistant may feel that a note disassociating himself
from the decision should be placed on file.
1070
However, the decision as to the notes inclusion in the audit working papers will be made by
the audit manager or partner and in reality, it is unlikely to be included in the file. The audit
manager is likely either to disagree with the audit assistant in which case no note will be filed
or agree with the assistant in which case additional work will be performed. The limited
extent of an audit assistants experience often leads to disproportionate significance being
given to certain matters. However, in this particular case, it is likely that the audit manager
will agree with the audit assistant and that the additional work will be performed.
1071
Answer 30 WICKET
(i) Weaknesses (ii) Consequences (iii) Recommendations
Collection of data
Hours worked are not authorised. Employees may be paid for work not done Mr Lamb should authorise hours to be paid
(eg by their clocking each other in and out at by initialling the clock cards. He should
earlier and later times). observe the clocking-in procedure regularly
to ensure it is not being misused.
The calculation of hours worked and the split Employees may be overpaid if hours are All hours worked and the overtime
between basic and overtime for each employee over calculated or too many are attributed to element, should be calculated and recorded
is not subsequently checked. overtime. before the clock cards are given to Mrs
Gooch. This could be done manually by
Employee goodwill may be lost if
Mr Lamb or by a new facility to the
underpayment arises from error in the
clocking-in system. Mrs Gooch should
determination of hours worked and the
countersign clock cards as evidence of
element of overtime.
having checked the hours calculated.
Processing
No controls exist over the accuracy of the Employees may be paid for hours not Mrs Gooch should calculate batch totals of
total, basic and overtime hours input to the worked or at the wrong hourly rate. basic, overtime and total hours and record
computer. these before passing the cards to Mrs
Smith.
The payroll should be reviewed (for

reasonableness of amounts) by one of the
cheque signatories (Mr Lewis or Mr
Stewart).
1072
(i) Weaknesses (ii) Consequences (iii) Recommendation
No controls exist to ensure that all (and only) If a clock card is lost: Mrs Gooch should batch the clock cards
valid clock cards are processed in the correct and record the total number to be
it may not be possible to verify the
period. processed. Miss Smith should agree/
hours worked;
reconcile this to a computer-generated total
employee goodwill may be lost; at the end of the payroll run.
it will be administratively time-
consuming to make individual
payments.
Security/confidentiality
Only one password is used to access the Unauthorised access could result in: The hierarchical password facility should
computer for all functions. be used and passwords changed
corruption of standing data;
periodically.
data loss.
Backup procedures are inadequate as the zip If the hard disk data is lost/damaged, its The zip disk should be stored securely, in a
disk copy is not kept secure and could be lost/ retrieval would be costly and time- fireproof safe, outside the accounts office.
damaged. consuming in the absence of the zip disk.
Review/maintenance of standing data
Standing data is adjusted for starters and Financial loss could result if: Mr Lambs list of starters and leavers
leavers without authorisation. should be signed, as authorised, by Mr
new employees are taken on when idle
Lewis. Mr Lewis should review all
time/ spare capacity is available;
standing data amendments logged by the
leavers are not removed and computer.
subsequently paid.
1073
Other points
Collection of data
Mrs Gooch is not notified promptly of starters A new starter may work without a clock A copy of the authorised list of starters and
and leavers and may therefore write up card making it impossible to check their leavers should be given to Mrs Gooch
inaccurate clock cards. hours. weekly before she prepares clock cards.
A leavers clock card may be used by
another employee causing a leaver to be
paid.
Review/maintenance of standing data
There is no overall supervision of the payroll Financial loss may result from: The number of each category of employee
function. should be budgeted by Mr Lamb and Mr
undetected (and therefore uncorrected)
Stewart. The actual monthly costs should
overpayments;
be reviewed by Mr Lewis, compared with
absence of monitoring of hours budget and variances followed up.
worked, idle time, overtime, numbers
of employees etc.
No independent personnel records are kept Payroll errors may go undetected if Personnel records and notifications and
outside the payroll function. personnel records are not kept up to date changes should be kept by Mr Lewis. He
and checked (eg if a leaver is not removed should check periodically the computer
from the payroll). standing data against these records.
No controls exist to obtain the necessary If the correct tax forms are not obtained, Standard checklists of documents required
documentation from starters and to prepare incorrect deductions may be made from a from starters and for leavers should be
documentation for leavers. starters wages. The company would be used.
liable for any underpayment of tax.
Security/confidentiality
Personnel records are kept by the payroll clerk Staff looking for other records may gain Personnel records should be kept by Mr
in a filing cabinet which also contains other unauthorised access to confidential details Lewis, not with files in the payroll office.
records. relating to other employees (eg details of
maintenance payments).
1074
Answer 31 COSMO
(a) Errors and misappropriations
Errors and misappropriations that may occur if purchases and capital expenditure are not
properly controlled include:
Purchases for goods and capital items the company cannot use resulting in wasted
resources and operational difficulties.
Not obtaining the best prices available.
Purchases for goods and capital items for the personal use of staff (i.e.,
misappropriation).
Incorrect recording and classification of purchases and capital items.
Non-payment for, or overpayment in respect of, purchases and capital items.
Payment for purchases and capital items not received due to suppliers issuing
fictitious invoices.
Purchase of goods and capital items from suppliers with whom internal staff collude
to pay inflated prices (segregation of duties is necessary to prevent this).
(b) Report to management
Weakness and consequences: The overall structure of the system is complex,

resulting in wasted management time in classifying purchases and capital items.
Recommendation: That the systems should be simplified to avoid management

time being spent on what are essentially clerical duties. The budget setting process
should be more realistic to avoid the need to classify capital items as purchases.
Weakness and consequences: There is an out of date ordering system and an

informal method of inputting changes. This results in wasted time in correcting
orders produced automatically.
Recommendation: That the system be updated the time spent making

adjustments is almost certainly greater than the time it would take to update the
system.
Weakness and consequences: Buyers consortium system and changes to orders:

changes to orders are made by the production controllers junior managers and the
buyers consortium system can only be used by them. This represents a lack of
segregation of duties; those with access to the assets (those involved in production)
should not also be able to execute the transaction (which should be done by the
buying department). Whilst collusion with the buyers consortium seems unlikely, it
is possible that goods the company does not need at all could be purchased.
Recommendation: That the buying department take over the responsibility for
dealing with the buyers consortium and that staff operating the system are properly
trained in its use.
Weakness and consequences: The buyers consortium system is taking up a large

amount of system space and may be causing problems with other systems.
1075
Recommendation: That additional space be made to accommodate the system and

that the software is investigated by systems engineers to establish the optimum
technical solution.
Weakness and consequences: Only part of the buying takes place using the
consortium which may be inefficient.
Recommendation: That a review of the effectiveness of the use of the consortium

be undertaken to establish whether to move more purchasing to the system.
Weakness and consequences: The systems for budgeting and authorising capital
expenditure and purchases are structurally weak as staff appear to find it necessary
to circumvent the rules in order to do their jobs; the systems are also operating
inefficiently as unauthorised capital expenditure is regularly incurred. It appears on
the face of it that the structural problems are giving rise to the operational
difficulties, although the operational difficulties may be independent of the
structural weaknesses.
Recommendation: That the structure and operation of both of the systems be

reviewed in detail in the light of the operation of the business as a whole.
Note: Answers might also be presented in a columnar format.

Answer 32 BEARSWORLD
(a) (i)
Analytical Procedures consist of evaluations of financial information made by a study of

plausible relationships among both financial and non-financial data.
Inquiry means to seek relevant information from sources, both financial and non-financial,
either inside or outside the company being audited. Evidence may be obtained orally or in
writing.
Inspection is the physical review or examination of records, documents and tangible assets. It
may include examination of records for evidence of controls in the form of a compliance test.
Observation involves looking at a process or procedure as it is being performed to ensure that

the process actually works as documented.
Re-calculation means the checking of the mathematical accuracy of documents or records.
(ii) Analytical Procedures.
Review of sales income year on year to try to identify whether income has been under-stated,
possibly by cash being taken prior to banking. There is no control over the opening of post so
cash could be withdrawn by one assistant, and the deficit made up by a fraud on customers.
Inquiry
Obtain statements from suppliers to check the completeness of liabilities at the end of the
year. As there is no control over purchases, invoices could have been mis-placed resulting in a
lower purchases and suppliers figure.
1076
Inspection
The assets of the company, namely cuddly toys in inventory at the end of the year, can be
inspected to ensure all inventory is recorded and that the toys are saleable in their current
condition.
Observation
Procedures such as the opening of cash and recording of customer orders can be observed to
ensure that the administrator is recording all orders in the sales day book and cash books.
Re-calculation
Checking additions in the cash book to confirm that the total amount of cash recorded is
accurate and can be included in the sales figure (cash receipts normally equal sales because
there are no receivables).
(b) Analytical procedures
This method of collecting evidence will be useful in BearsWorld because it will help to
identify unusual changes in income and expenditure. As BearsWorld is a relatively small
company, monitoring gross profit will show relatively small changes in sales margin or
purchasing costs. Decisions by Mr Kyto to amend margins can therefore be traced into the
actual sales made.
However, the technique may be limited in its application because it will not detect errors or
omissions made consistently year on year. If either assistant is defrauding the company (for
example by removing cash) each year, then analytical procedures will not detect this.
Inquiry
Inquiry evidence will be very useful in the audit of BearsWorld, especially where this is
derived from third parties. Third party evidence is generally more reliable than client
originated evidence as there is a decreased likelihood of bias. Suppliers can therefore be
verified using supplier statement reconciliations. A review of any customer complaints file (if
these letters are kept) will also help to identify any orders that have not been despatched.
External inquiry evidence will be less useful in the audit of sales and receivables because
goods are paid for prior to despatch there are no receivables. Internal evidence will be
available from Mr Kyto and the assistant; however the lack of segregation of duties means
that this will not be so reliable.
Inspection
Inspection of documents within BearsWorld will be useful, particularly regarding checking

whether expenses are bona fide. All purchase invoices, for example, should be addressed to
BearsWorld and relate to purchases expected from that company e.g. cuddly toys for resale,
office expenses etc.
Inspection of documents can take a long time; however, given the poor internal control
system within BearsWorld, the auditor may have no choice but to use this method of
gathering evidence.
1077
The fact that an invoice is addressed to the company does not confirm completeness of
recording so inspection of the cash book for unusual payments verified by checking the
purchase invoice will also be required. Additional substantive testing would also be required
due to poor controls.
Observation
Observation may be useful because it will show how the assistants check documents.
However, no information is provided on any internal controls within BearsWorld so simply
viewing how documents are checked without any evidence of checking has limited benefit.
Observation tests will be of limited usefulness because the assistants may act differently when
an auditor is present. The same problem will apply to any observation checking carried out by
Mr Kyto.
Re-calculation
Re-calculation evidence is very useful for checking additions on invoices, balancing of

control accounts etc. This means that the arithmetical accuracy of the books and records in
BearsWorld can be confirmed.
The main weakness of re-calculation checking is that calculations can only be carried out on
figures that have been recorded. If there are any omissions then checks cannot be carried out.
1078
Answer 33 GORDON
Test (a) Objective (b) Assertion(s) (c) Reliability
2 Test of operation To verify the occurrence of purchase transactions by As evidence obtained directly by the auditor it provides very reliable
of control. ensuring that the goods receiving clerk properly evidence of the procedure observed. However, it provides less
inspects the contents of deliveries as being undamaged reliable evidence about the performance of procedures relating to
and in agreement with the delivery note and purchase goods delivered generally, especially if the clerk knew he was being
order. observed.
3 Substantive test To verify the completeness of recorded purchase Reliable in that the evidence is obtained directly by the auditor.
of details of transactions by ensuring that all goods received are However, the reliability is subject to further evidence that all
purchase recorded in the accounting records. deliveries are recorded on goods received notes.
transactions.
4 Test of operation To verify the occurrence of recorded purchase Documentary evidence of the procedure having been performed is
of control. transactions by ensuring that the control procedure of less persuasive than observation of the performance itself. However,
independently checking invoices with supporting the employees responsible have acknowledged, by initialling the
documentation is evidenced as having been performed. invoice, proper performance of the procedure and may thus be held
accountable if they are found to have performed their task carelessly.
To this extent the evidence is reliable.
5 Analytical Provides evidence on the existence, completeness and As auditor created evidence, the computation of the relationship,
procedure as a valuation of the accounts payable balance. If the such as a ratio, is reliable. However, the reliability of analytical
substantive closing balance, relative to purchases, is higher than evidence is subject to the ability to develop expectations. If the
procedure expected, the balance may include liabilities that did not incidence of purchases during the year and the entitys payment
relating to the exist at the end of the reporting period or that individual policy are unchanged, last years relationship provides a reliable
accounts payable liabilities included in the balance are overstated. If the basis for developing an expectation for the current year.
balance. closing balance, relative to purchases, is lower than
expected, the balance may be incomplete through the
omission of liabilities that existed at the end of the
reporting period, or the understatement of individual
liabilities included in the balance.
1079
Test (a) Objective (b) Assertion(s) (c) Reliability
6 Substantive test Provides evidence on the valuation of the accounts As auditor created evidence it is highly reliable. However, the
of details of payable balance. auditor will also need to obtain evidence that the list of accounts
accounts payable balances has been properly taken from the ledger.
payable By virtue of the double entry system, any errors in the
balance. following are likely to be revealed by a failure of
individual creditor balances to agree, in total, with the
balance on the control account:
in entering individual transactions in the purchase
journal, cash payments journal or purchase ledger,
in adding journals and posting totals to the ledger,
in determining the closing account balances.
7 Test of design Provides evidence on the completeness and existence of In so far as the auditor evaluates the effectiveness of the design of
of control. recorded purchases during the period. If cut-off cut-off procedures the evidence is reliable. There is always the risk
procedures are reliable, the control risk of purchase that management may deliberately misinform the auditor.
transactions being recorded in the wrong accounting Nevertheless, if the auditor considers the procedures are effectively
period is reduced. designed, further tests of control need to be performed to ensure the
procedures are properly operated. Because of inherent limitations of
control, assessment of control risk as less than high always involves
an element of uncertainty.
1080
Answer 34 CONFIRMATIONS
(a) Management representations
Evidence
Auditors obtain written representations from management on material matters

where other sufficient appropriate audit evidence cannot reasonably be expected to
exist. ISA 580 Management Representations deals with this subject.
Such matters might include confirmation that all related party transactions have
been disclosed in the financial statements and confirmation of all matters that rely
principally on the exercise of judgement by directors such as soft provisions.
The letter also usually includes confirmation that all matters occurring since the end
of the reporting period that should be brought to the attention of auditors have been
brought to their attention, and that all of the accounting records have been made
available to the auditors.
Management representations should not conflict with other audit evidence. If they
do, the matter should be investigated and resolved.
Practical difficulties
In practice, it is not always easy to obtain a signed management representation

letter. The letter should be addressed from the client to the auditor, but it can take
the form of a letter from the auditor to management that is acknowledged by
management, or signed minutes of a board or similar meeting.
If management refuse to provide representations, this may be grounds for a

qualification of the audit report on the basis of a limitation in the scope of the audit.
However, this is an extreme step and auditors will always discuss with directors
alternative wordings that will be acceptable to them before considering qualification
of the audit report. There may be genuine uncertainty on the part of management as
to the reasonableness of the representations that auditors request them to make.
Alternative evidence
Unfortunately, because of the content of these letters, there is very little alternative
evidence; that is why the letter is requested in the first place.
Auditors need to think carefully about the content of the letter if management
refuses to sign altogether, and consider whether there is alternative evidence,
whether the matters are truly material and whether an audit qualification is needed.
Auditors can exert some pressure on management to sign by making this threat, in
practice.
(b) Direct confirmation of receivables
Evidence
Auditors often seek direct confirmation of receivables to ensure that the amounts
stated in the entitys accounts receivable ledger are not overstated. Confirmation
also provides evidence in relation to certain frauds and the quality of internal
controls.
1081
Confirmation that an amount is owed is not confirmation that the amount will be
paid and auditors need additional evidence on the recoverability of receivables.
There are two types of confirmation, positive and negative. In the former case, the
customer is requested to reply in any case, and the auditor can either insert the
balance to be confirmed or the customer can be requested to do so. In the latter case,
a reply is only requested if the customer disagrees. This method is only suitable
where receivables are well-controlled.
The response rate to requests for confirmations is not always satisfactory and
repeated requests may be necessary. It is not uncommon for replies to be inaccurate,
especially where the amount stated is too low.
Where the customer is requested to insert the balance, the reconciliation can
sometimes be very difficult, even with the help of the client, and the customers
assistance may be needed.
Where no reply is received it is important that alternative evidence is obtained on

the same balance (and not to test another balance). Where there is a discrepancy
between the clients records and the customers records, the matter should be
investigated and resolved.
Sometimes, the customer can provide a reconciliation, particularly if the matter only
relates to timing differences. On other occasions there may be a dispute and a
provision may be necessary.
Alternative evidence for receivables includes payment of the amount after the
period-end, a review of contracts and signed delivery notes, and analytical
procedures on the ageing of receivables.
(c) Confirmation of inventory held by third parties
Evidence
It is often not possible for auditors to confirm inventory held by third parties by
attendance at an inventory count and therefore the only evidence available is
confirmation from the third party.
It is particularly important to ensure that the confirmation is genuine because of the

possibility of fraudulent collusion between the third party and the client to inflate
inventory and profit figures.
The reliability of service from the third party and the quality of documentation and
correspondence are all taken account of as part of the auditors risk assessment in
this area.
1082
Both the quality and quantity of inventory held should be confirmed. It is common
for third parties to use different descriptions or units of measurement in their
records to those used by the client and it is necessary to reconcile these items.
It may be possible for the auditor of the third party to provide some evidence in
relation to the amounts held.
If the inventory held by the third party is likely to be material, the auditor must
consider the possibility of visiting the third party and attending the inventory count.
The auditor may review and test the controls over the movement of inventory to and
from the third party and the related records, in order to reduce the level of
substantive evidence needed at the period-end.
Records that show negative inventory (more outs than ins) at either the client
or the third party may be indicative of misclassifications, for example.
(d) Reports provided by auditors of service organisations
Evidence
Where an entity has out-sourced a significant element of its accounting function to a

third party, as is increasingly common, the auditor may be forced to assess control
risk as high in that area unless he can perform tests of control.
In testing controls, it may be appropriate for auditors to obtain a letter from the
auditors of the service organisation. Such letters confirm either the suitablility of the
design of the system, or the suitability of the design of the system and its operating
effectiveness.
Only where the latter type of report is obtained can the auditors reduce their
assessment of control risk and perform reduced substantive testing. The auditors
should also consider the competence and experience of the service organisations
auditors.
Practical difficulties and alternative evidence
The alternative is to visit the service organisation in order to perform tests of

controls, although this may be impracticable because it might be located on the
other side of the world, for example. It may also be costly because it will be
necessary for the auditors to obtain a working knowledge of the third partys system
before it can be tested. Such systems can be complex.
Auditors have no right to visit the third party or test controls there; if it is considered
absolutely essential to do this, the client may have to bring pressure on the third
party to permit it.
In practice, a client that has out-sourced a significant element of its accounting (or
other) functions to a third party may well have made arrangements in respect of
auditors as part of the contractual arrangements with the third party.
1083
Answer 35 JUST CRUST
(a) Nature and purpose of analytical procedures
Analytical procedures involve:
the analysis of significant ratios and trends;

the investigation of fluctuations and relationships that are inconsistent with
other relevant information (or which deviate from predicted amounts).
Analytical procedures include the consideration of:
comparisons of the entities financial information with, for example,

similar industry information;
relationships between financial and non-financial information.
Procedures may involve simple comparison of current with prior years or a review
of variance accounting.
They are used:
to assist in audit planning the nature, timing and extent of other audit
procedures;
as substantive procedures (when more effective or efficient than tests of detail);
as an overall review.
(b) Extent of use
At the planning stage, analytical procedures assist in understanding the entitys

business and identifying potential risk areas.
Substantive procedures, such as test in total, may be effective in reducing

detection risk for specific financial statement assertions (eg regarding rental income,
interest payable, depreciation, etc).
Conclusion drawn from analytical procedures as part of the overall review of

financial statements should corroborate conclusions drawn on individual audit areas.
Substantive analytical procedures
Analytical procedures can themselves provide sufficient audit evidence where an

item can be verified directly by reference to another (valid) item.
Analytical procedures may be effective in testing for understatement (ie complete-

ness). For example, in predicting sales from purchases and known margins.
Where sufficient substantive evidence is not obtained by analytical procedures

alone, some tests of detail will also be required.
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Greatest use of substantive analytical procedures is where:
existing client is well established;

well known industry is stable;
predictive information is available (eg budgets);
accounting and internal control systems are effective.
(c) Substantive analytical procedures
Tutorial note: Just Crusts inventory is minimal.

Sales (broken down by product and in total)
Compare variations by month with the previous year. Investigate seasonal

fluctuations which are inconsistent.
Ascertain reasons for volume increases or decreases in sales, especially where the
movement is contrary to the industry trend.
Compare sales in volume terms with manufacturing capacity.
Compare production with delivery records.
Reconcile sales value with previous year by reference to production levels and
selling price increases.
Compare and explain fluctuations in the following ratios:
Delivery costs : sales

Discounts allowed : sales
Productive labour : sales
Agree/reconcile turnover to VAT (sales tax) returns.
Purchases
Reconcile raw material purchases (flour etc) with production records and industry
averages for price increases.
Compare and explain fluctuations in the following ratios:
Carriage in : raw materials

Discount received : raw materials.
Compare costs of material consumed.
Gross margin and cost of goods sold
Compare with previous years.

Review percentage against industry average.
Compare with clients mark-up percentage.
1085
Manufacturing overheads
Compare variable production overheads (eg lighting and heating) with previous year
by reference to production levels and general price increases.
Compare fixed production overheads with previous year by reference to general

price increases.
Compare output per production worker (each baker) with corresponding figures for
previous year.
Salaries and wages
Compare, explain and substantiate fluctuations in the following:
Social security expense : payroll

Pensions scheme expense : payroll
Holiday pay : wages.
Schedule payroll expense by week or month and explain fluctuations by reference to
staff changes, pay rises, holiday pay, etc. Compare total with comparative figures and
rationalise by reference to overall staff levels and pay rises (proof in total).
Other statement of comprehensive income expenditure
Compare where relevant:
rent with annual rent per rental agreement;
rates with previous year and known rate increases;
other items related to activity level (eg advertising) with price increases
and changes in relevant level of activity;
other items not related to activity with general (or specific) price increases;
vehicle running expenses to number of vehicles;
vehicle running expenses (excluding wages) to mileage.
Statement of financial position
Compare and explain fluctuations in the following:
Solvency ratios
(1) Current assets : current liabilities

(2) Liquid assets : current liabilities
(3) Collections period
Capital ratio (gearing).
1086
Other
Make comparisons using significant accounting ratios, in particular those relating to:
profitability
liquidity
capital gearing.
Compare items with budgets or forecasts, and with previous periods. Specific
comparisons should include:
breakdown of sales into products;

costs of productive labour compared with sales;
costs of variable overheads compared with sales;
returned and unsold goods compared with production;
fixed assets, depreciation, and vehicle running costs.
Determine monthly trends, using management accounts, and take into account:
changes in the expected direct relationship between raw materials

purchases, production, and sales (minimal inventory being held in the
bread industry);
changes in the buying habits of the public (eg moving from processed to
wholemeal bread);
any unexpected variations in capital expenditure on vans, which might

indicate an expansion or contraction (actual or anticipated) in sales;
labour unrest in the bakery industry on a national level; and
any undercutting of the companys prices by imports of frozen bread or cakes.
Answer 36 VILLAWOOD
(a) Acceptable explanations
Tutorial note: Only one explanation is required for each ratio. Acceptable means
satisfactory/appropriate/legitimate rather than a good thing.
Days sales in accounts receivable
Change in Villawoods normal credit terms such as from 30 days to 60 days (eg in a
time of recession).
Change in the mix of products sold or customers supplied to which different credit
terms applied. For example, certain privileged customers could be granted longer
credit than others or certain products (eg higher value lines) could be sold with a
longer credit period. Greater sales to such customers or of such products would
result in a higher number of days sales in closing accounts receivable.
A move from cash to credit sales (ie extending credit to customers previously dealt
with on a cash only basis).
Relative increase in closing receivables of customers who are slow but reliable
payers (eg government bodies).
1087
Inventory turnover
Tutorial note: The movement must be correctly interpreted as slowing if explanations are
to be acceptable.
Deliberate policy to increase inventories to avoid shortages or to concentrate on
lines offering higher margins but having a slower turnover.
Deliberate inventory build-up in anticipation of a major sales campaign or new

product launch shortly after the year end.
If Villawood is a manufacturing company it could be a change in manufacturing

processes requiring greater holdings of materials and work in process.
Depreciation expense
Change in the relative types of asset to those having longer useful lives.
Re-assessment of the useful economic lives of existing assets.
Assets having become fully depreciated (or a greater proportion of such assets).
Significant assets having been disposed of and not replaced.
Repairs and maintenance
Increased incidence of plant breakdown.
Change in type of plant requiring more costly maintenance.
An unusual incidence of major overhauls occurring in the same year.
(b) Possible misstatement
(i) Days sales in accounts receivable
This could be due to an understatement of credit sales or an overstatement of accounts receivable.

The understatement of credit sales would need to be of substantial proportions and it does not
appear that the level of turnover has been identified as unusual. Overstatement of accounts
receivable could be due, either to the overvaluation of recorded receivables or cut off errors
leading to the incompleteness of recorded cash receipts or the recording of sales transactions that
did not occur in the period.
1088
(c) Substantive tests of details
Overstatement of accounts receivable Test postings to accounts receivable
If the ratio is based on accounts

Tutorial note: A misposting to the accounts
receivable net of the provision
receivable control account is unlikely to be
for bad debts, the unusual
associated with an identical misposting to the sales
relationship could be due to an
ledger.
underprovision for bad debts. It
is possible that accounts Reconciliation of the sales ledger with the
receivable could be accidentally control account will minimize undetected
overstated by a gross error in misposting to the control account. Test the
bookkeeping (eg a miss posting listing of accounts receivable to and from the
to the control account). receivables ledger, add the listing and agree it to
the control account.
Debit postings towards the year end can also be
analysed for unusual items, which might
represent mispostings. Similarly credit postings
from cash receipts can also be traced to the
control account to ensure none were not posted
or posted to the wrong account.
Sales cutoff Sales cutoff test
Cutoff errors provide a possible The cutoff test involves vouching sales recorded
explanation. The most likely is before the year end against dispatch notes to
the inclusion in sales of goods ensure all were delivered before the year end.
not shipped until after the year Sales returns and allowances after the year end
end. This could be done also need to be vouched to ensure they do not
deliberately in order to boost relate to fictitious sales before the year end.
profits or meet sales targets.
The circularisation of receivables will also
provide evidence of cut-off errors if a substantial
number of customers indicate disagreements. (It
is not always easy, however, to distinguish goods
in transit from cut-off errors.)
Cash receipts cutoff Cash receipts cutoff test
The failure to record cash If cash cutoff was checked by attendance at the
received prior to the year end companys premises at the year end, following
until after the year end is up the information recorded will confirm cut-
possible but much less likely. off.
Otherwise it will be necessary to scrutinise
records of cash receipts from credit customers
recorded after the year end to ensure that none
appeared to have been received earlier.
(ii) Inventory turnover
The error could be due to an overstatement of inventory or an understatement of purchases or cost

of goods sold. Overstatement of inventory could be an error in ascertaining the quantity or value
of closing inventory. The understatement of purchases would most likely to be due to a cut-off
error.
1089
(c) Substantive tests of details
Understatement of purchases Purchases cutoff test
Understatement of purchases is Purchases cutoff is best tested by vouching

most likely to be caused by a purchases recorded after the year end to goods
deliberate cutoff error resulting received notes recording delivery as also being
in the incompleteness of after the year end.
recorded purchases.
The alternative approach is of tracing goods
It could be caused accidentally received notes issued before the year end to
by misposting. It is possible that purchase records to ensure none are omitted.
purchase transactions or other
production costs could have
been posted to some other
expense account. However, this
seems unlikely as, apart from
repairs and maintenance, no
other account appears unusual.
Overstatement of inventory Test existence and valuation of closing inventory
Inventory could be overstated by Follow up of evidence recorded at physical

the inclusion of inventories that inventory attendance would need to be
did not exist or by overvaluing particularly thorough in verifying the existence
inventory. of recorded inventory and the reliability of the
cut-off of deliveries.
Tests of valuation during the final audit will
need to consider the increased possibility of the
overvaluation of inventory.
(iii) Depreciation
Depreciation is an estimate based on Tests of the calculation of depreciation would

judgement and the error could only need to be thorough.
be one of valuation. This could be:
The rates applied to additions during the year
should be consistent with last year. If these are
a clerical error in the calculation;
lower than on existing assets, managements
or
assessment of increased useful lives should be
a failure to provide adequate reviewed.
depreciation.
(iv) Repairs and maintenance (c) Substantive tests of details
The most likely error is of additions Entries to the repairs and maintenance account
to plant and equipment being mis- would need to be vouched to source
classified as repairs and maintenance. documentation to ensure that the transaction is
This would result in: properly classified.
the non-occurrence of recorded

repairs and maintenance
transactions; and
the incompleteness of recorded
plant and equipment transactions
and of the closing balance of
plant and equipment.
1090
Answer 37 AUDIT SAMPLING
Description
(i) Judgement and statistical sampling
Judgement sampling uses the auditors judgement to select the number of items to be tested,
which items to be tested, and to interpret the results. Statistical sampling uses probability
theory to do the same. Some judgement is always used in statistical sampling in the
assessment of materiality and in the determination of what constitutes tolerable error, for
example.
(ii) Representative sample
A representative sample is one whose characteristics are the same as, or similar to, the
characteristics of the population as a whole. All sample selection methods attempt to select
samples that are representative.
For example, a sample of invoices that have not been properly authorised in 5% of cases will
be representative of all invoices if the population as a whole also has around 5% of invoices
not authorised.
(iii) Tolerable error
Tolerable error is the maximum error that the auditor is prepared to accept and still conclude
that the audit objective has been achieved.
For example, in relation to receivables, the auditor may be prepared to form the conclusion
that receivables are not materially misstated if sampling shows that the receivables population
has a value that is within plus or minus, say, 5% of the figure in the financial statements.
(iv) Different methods of sample selection
Random selection requires the use of random number tables in order to select a representative
sample.
Haphazard selection may be deemed to approximate to random selection provided that no bias
is displayed.
Interval (or systematic) selection involves taking every nth item, starting at random. Monetary
unit sampling is also a form of systematic selection.
Block selection methods (taking one full part of the population) will probably not result in a
representative selection. Block selection might involve obtaining confirmation of receivables
from one region of the country only, for example.
NB: Only two examples are required.
(v) Extrapolation of errors
Errors found in a sample are extrapolated across the population as a whole, in order to enable
the auditor to form a conclusion on whether the population is materially misstated. It is
important to remember that there is not necessarily a direct, linear relationship between errors
in samples and errors in the populations from which they are drawn.
1091
Answer 38 STRATHFIELD
(a) Method of selecting items for confirmation
(i) Inconsistencies with sampling
To be a sample, each item must have an equal chance of selection. Sarahs approach does not
meet that requirement in that:
all large accounts are selected;

no accounts under $100 are selected;
no government accounts are selected.
Selecting all large accounts for testing is quite common but the basis for defining large
needs explanation. The population being sampled is then defined as all receivables balances
below the threshold for items selected as large.
Ignoring very small balances is irregular but, in a test primarily concerned with testing for
overstatement and valuation, unlikely to affect the results. However, her working paper
should, again, explain the basis for determining the cut-off point of $100.
Treating government accounts as a separate sub-population is acceptable providing alternative

verification is performed on such accounts. Moreover, the total of government accounts in
the ledger should be treated as a separate sub-population when projecting the sample results.
Merely excluding them as being too difficult is not acceptable.
(ii) Alternative approach to selection
The two preferred methods of drawing a sample from variable populations to ensure a
sufficient sample of more material balances are stratification and monetary unit sampling.
Stratification divides the population into strata by value and draws relatively larger samples
from higher value strata than lower value strata. Sarah has actually done this but not in a
formalised way. Statistics can enable auditors to determine the optimum stratification to
obtain the required assurance from the smallest sample. In evaluating results error rates need
to be projected separately to each stratum.
Monetary unit sampling identifies individual $s as the sampling unit. By systematically

selecting $s, the larger the account balance the larger its chance of containing a $ being
selected and thus being tested. Each $ is regarded as being in error proportionately to the
error in the account balance of which it forms part.
(iii) Haphazard selection
Haphazard selection is an acceptable method of drawing a sample but introduces the risk of
unconscious bias such as neglecting the first or last items on a page.
Systematic sampling overcomes this by requiring the staff member to follow a prescribed
order. Selection can be replicated and any instances of failure to select the required sample
detected. It is not convenient for populations in which the sampling units are not sequentially
ordered. It also presents the risk that there may be a particular pattern to the population,
which recurs at the same interval as the sampling interval.
1092
Random selection can be undertaken by use of random numbers generated by computer or

random number tables. In both cases bias is avoided by requiring the staff member to justify
reasons for not testing the sampling unit selected by computer or through use of random
number tables. It is inconvenient for populations not held on a computer in that physical
selection of documents in random order can be time consuming. It is also not appropriate for
sampling units, which are not serially numbered, such as inventory items.
(b) Qualitative analysis of errors
Address unknown
These affect the valuation assertion since the amount is potentially uncollectable.
The extent of the error depends on whether the company does have a forwarding
address.
Assuming there is no forwarding address the error is one that may be projected to
the population.
Cut-off
Since these have been established as goods or cash in transit, they are not misstatements and
do not constitute errors.
Invoicing errors
These would appear to result from a weakness in control.
The cause of discovered errors must be investigated as to whether they are

consistent with the assessed level of control risk for invoice pricing.
If they suggest a higher level of risk than that originally assessed the level of
substantive procedures may need to be reconsidered.
It may be they occurred during a particular point in time such as when the invoicing
clerk was on holiday in which case further testing may be required on the sub-
population of invoices prepared at that time.
Otherwise they are consistent with expected errors and must be projected to the
population.
Posting errors
These would appear to result from control weaknesses. Although there is a slight risk of such
errors resulting in accounts becoming uncollectable, the fact that the customer to whom they
are wrongly charged is likely to complain means that the error is likely to be detected and
corrected within a reasonable time. The auditor is not unduly concerned about controls or
discovered errors in a situation where monthly statements are issued and customer queries
independently investigated. Assuming that to be the case, the error would not be regarded as
a misstatement.
1093
Disputed items
Each dispute is likely to be unique. The auditor must investigate each one to see if it is part of
a material sub-population. For example it could reveal problems with a particular product and
may require a provision against all outstanding sales of that product and even against unsold
inventory. If the individual issues are isolated but symptomatic of errors that could be present
in the population the error must be projected to the entire population.
(c) Projected error
In projecting the error material accounts selected for testing should be excluded from the
population samples. In theory, balances below $100 and with government customers should
be excluded. However, the former are likely to be immaterial in total and may be ignored and
we have no information as to the latter.
It is assumed that our qualitative analysis has determined that all errors except for cut-off
differences and mispostings should be projected to the population. It is also assumed that the
ratio method is appropriate.
Recorded value of sample $265,450

Errors
Gone away 950
Invoicing ($2,800 $2,200) 600
Disputes ($2,800 $1,300) 1,500 3,050
_____ _____
Percentage error 115%
_____
Total accounts receivable $2,350,000
less material items selected 205,000
_________
Population sampled $2,145,000
_________
Error rate 115%
_________
Projected error 24,668
Errors in material items 0
_________
Total possible error $24,668
_________
Alternatively:
Errors known (in 6,500) 3,050

Projected error (on 2,138,450) 24,592
_________
Total possible error $27,642
_________
Sarah must consider, in the light of the total possible error, whether to conclude that accounts
receivable are not materially misstated.
1094
Answer 39 NEWTHORPE ENGINEERING
(a) Audit work on estimates
Obtain a schedule identifying the assets and employees who are being made redundant as a
result of closure of the factory. It will be easier to identify these items if the whole factory is
being closed:
plant and equipment should be identified in the fixed asset register; and
employees should be either on a separate payroll or otherwise separately identified.
(i) Net realisable value plant and equipment
Obtain a schedule of the fixed assets and the estimated or actual disposal proceeds.
In most cases there is likely to be a loss on disposal, unless the fixed asset is fully
written off.
To check completeness of the population being examined, agree (or reconcile) the
cost and depreciation on the fixed asset register to the figure in the companys
accounting records and the draft financial statements.
Obtain separate schedules of plant which is sold and plant which is unsold. Test
check the completeness of plant and equipment on the schedules by selecting items
of plant from the fixed asset register and checking they are on either the plant sold
schedule or the plant unsold schedule.
For selected items of plant which have been sold, agree the sale proceeds to sales
invoices and cash book receipts. There may be costs of disposal (eg unfixing or
dismantling the plant) which will have to be deducted from the sale proceeds if
Newthorpe has agreed to pay these costs.
If the item has not been sold, obtain details of the plant and its estimated sale
proceeds. If the sale proceeds are small (eg scrap value) confirm that this is
reasonable (eg in relation to the age and condition of the asset). If estimated
proceeds are substantial, ask the companys staff why they are so large and whether
potential buyers have expressed interest in purchasing them. Inspect
correspondence or other evidence of interest by buyers (eg in response to sale
advertisements).
Further consider whether estimated sale proceeds are reasonable by comparison

with actual proceeds received from the sale of similar assets.
Increase the sample of items to be checked if the companys estimates are

unreliable.
Discuss any significant differences with the directors. If they refuse to change the
figure in the financial statements to reflect apparent impairment losses, include the
difference in the schedule of unadjusted errors. (The auditors report should be
qualified if the total of the unadjusted errors is material.)
1095
(i) Net realisable value inventory
Obtain a schedule of the actual and estimated proceeds of sale of the inventory.
Tutorial note: The question clearly states that the physical count was carried out
at the year end and that inventory quantities have already been determined to be
accurate.
Using details of year-end inventory from the inventory sheets (as a basis for
identifying the inventory which is sold after the closure) select a sample of
inventory of inventory, probably using monetary unit sampling.
For inventory which has been sold, agree sale proceeds to sales invoices and cash
book receipts. For some items, it may not be possible to identify the selling price as
a number of products may have been sold in a single transaction. If this has
happened, the allocation of sale proceeds against the inventory sold should be
reviewed for reasonableness.
For inventory which is unsold, consider whether the companys estimates are
realistic. Confirm that the disposal proceeds of clearly slow-moving or obsolete
items are estimated to be only small (if any).
For items where the estimated sale proceeds are large, ask Newthorpes staff the
reasons for such a high price being used. Obtain corroborative evidence such as
offers received from potential customers. Use judgement, based on knowledge of
the products and experience in other audits, to assess reasonableness (eg an estimate
of valuable material, such as lead, could be obtained from a scrap metal merchant).
For items which are unsold, net realisable value is sale proceeds less costs of sale.
Confirm the reasonableness of such costs (eg that costs of advertising and possibly
delivery to the customer are taken account of).
Unsold work in progress is likely to have a low value (if any) so should be
investigated if a high value has been attributed to it.
If the value of unsold inventory is significant, compare the ratio of net realisable
value to cost for unsold inventory against that for inventory sold. For example, if
inventory has been sold at 20% of cost, then it is unlikely that the remaining
inventory will be sold for 25% of cost, but a figure of 15% of cost for the unsold
inventory would probably be realistic.
As for plant and equipment, discuss any significant differences with the directors
(and include, as necessary, on schedule of unadjusted errors).
(ii) Redundancy cost
Obtain a schedule of the redundancy costs. Agree the basis for the redundancy
payments (as stated in the question), for example, to:
documented company policy;

contractual terms of employment;
terms minuted by the Board and announced to the workforce.
1096
Confirm that employees on the payroll just before the factory closed appear on the
list of employees being made redundant. For employees on the payroll who are not
on the list, verify that they have been transferred to another factory (eg they should
appear on a current payroll for that factory). Discuss with management any
employees on the list of those being made redundant who do not appear on the
factorys payroll at the year end.
For most employees, redundancy pay will be the weekly pay times the number of
years service.
For a sample of employees, agree the number of years service from the
start date recorded in their personnel records.
Ask what is meant by one weeks pay (eg basic pay (excluding
overtime) or a weekly average (including overtime)) and agree it (eg to
the weekly payroll).
Recalculate redundancy payments and compare with amounts paid.
For a sample of employees under a service contract, recompute the amount due
under the terms of their contract.
Test check the payments to the cash book to ensure they are the same as on the
companys schedule.
Check the addition of the employees redundancy pay and agree it to the provision
in the financial statements.
Ask if there are any disputes with employees over the amount they are to be paid (or
have been paid). Review correspondence with employees and Newthorpes legal
advisers for evidence of disputes. Discuss with management their opinion of the
final outcome, and consider the materiality of any additional amount that might
have to be settled (including legal costs).
Tutorial note: The last point could be expanded on, for external confirmation from legal
advisers and written management representation, but this part of the question carries only 4
marks.
(b) Unfair dismissal
(i) IAS 37 disclosure requirements for contingent liabilities
If the possibility of the obligation is remote no disclosure is required in the financial

statements.
Where the probability of the obligation is possible but not probable (ie < 50%), a
note about the contingent liability should be included in the financial statements
indicating:
the nature of the contingent liability;

an estimate of its financial effect (where practicable);
the uncertainties relating to the amount or timing of any outflow; and
the possibility of any reimbursement.
1097
Where there is a probable obligation, as a result of past events, the liability should
be provided for in the financial statements (unless a reliable estimate of the amount
cannot be made). In this situation the financial statements are required to make
disclosures about the provision also.
(ii) Audit work
Tutorial note: To determine whether the company will have to pay damages depend on
whether the likelihood of settlement is remote, possible or probable. The amount of
damages and costs which should be included in the financial statements will depend on the
sums the company may have to pay if it is successful or unsuccessful in defending its action in
dismissing the Managing Director.
To determine the likelihood of the Managing Director being successful in his claim:
Obtain a copy of his service contract and consider whether, under its terms, he could
be entitled to two years salary. If so, this would probably be the maximum sum he
could claim under this contract. Scrutinize the contract for any circumstances
which would prevent him making this claim (eg being dismissed for gross
misconduct).
Obtain a transcript of the companys disciplinary hearing held on 17th March and
discuss with management the details of the allegations of gross misconduct. Inspect
any evidence supporting these allegations (eg an internal report on fraud) and
consider whether the Managing Director has at any time agreed or refuted the
companys findings.
Ask about any developments since 17th March which could quantify the companys
potential liability relating to this claim. Read correspondence between the company
and the Managing Director (or between their solicitors). If the company has agreed
to make an out-of-court settlement, a provision for the payment should be
included in the financial statements.
It seems probable that the company will incur legal costs in defending the claim by
the Managing Director and these should be accrued in the financial statements. An
estimate of these costs should be obtained from the companys solicitor (with the
clients permission).
External confirmation from the companys solicitor should be sought regarding the
likely outcome of the case. In the unlikely event that the amount of damages
claimed is very material (eg so as to threaten the companys existence), further
independent legal advice should be sought.
Review Newthorpes insurance policy documents for any cover against such claims
and the legal costs. Obtain external confirmation from the insurance company (with
the clients permission) to confirm that it will reimburse any agreed settlements.
The insurance company may pay the legal costs, but not any damages awarded
against the company. Any reimbursement through insurance cover should be
separately disclosed in the financial statements (and not merely offset against the
liability).
1098
The reasonableness of the companys omission of any provision or disclosure in the

financial statements should be assessed based on the findings of the above
investigations. Although the company will probably want to avoid mentioning
dismissal of the director in the financial statements (because of the associated bad
publicity), if the likelihood of the company having to concede the Managing
Directors claim is less than remote (ie at least possible) there should be some
disclosure in the notes (whether a contingent liability or provided for). Also, the
company will probably have to pay its own legal costs, and these should be
provided for.
Answer 40 TWO COMMUNICATIONS
(a) Letter of representation
(i) Purpose
During the course of the audit many representations are made by management to the auditors.
Some of these are in response to direct enquiries by the auditors, others are implicit in the
preparation of financial statements that give a true and fair view. Most of these
representations will be confirmed during the course of the audit by more reliable evidence
such that reliance no longer need be placed on management representations. For other
representations, however, there will be no independent corroboratory evidence available. The
letter of representation, therefore, provides formal confirmation of the representations made.
In so doing, management may be encouraged to reflect more fully on the completeness of the
representations made and provide further information that may earlier have been overlooked.
Reliability
Failure, by the auditors, to confirm such representations in writing would constitute

negligence. However, it is important that auditors do not place reliance on representations
where more reliable evidence would be expected. The absence of corroboratory evidence
would, in itself, be suspicious and should lead to further audit enquiry. Moreover, written
representations do not necessarily constitute sufficient evidence. The auditor must consider
all available evidence and its reliability in forming an opinion. For example, in a small
business where significant audit reliance must be placed on management representations,
auditors may occasionally form the view that, even with written representation by
management, there is insufficient evidence on which to form an opinion.
(ii) Matters included
Disclosures of contingent liabilities and assertion of completeness of disclosure.
Identification of related parties and assertion of completeness of disclosure of

related party transactions.
Assumptions underlying accounting estimates where sufficient other evidence

cannot reasonably be expected to be available (eg projecting the outcome of long-
term contracts).
Unusual contract terms such as purchases with reservation of title and assertion of
completeness/adequacy of disclosure.
Managements plans that may significantly alter the carrying value or classification
of any of the entitys assets or liabilities (eg managements intention to settle a
matter out of court or sell a division).
1099
Occurrence of specific subsequent events.
Tutorial note: Only three are required. Other matters may also be considered relevant.
(iii) Effect of refusal on audit
If management refuse to provide written representation as requested, the reasons would need
to be enquired into and the effect on the overall sufficiency of evidence considered.
If refusal is due to managements uncertainty about the factual accuracy of an earlier verbal
representation then additional procedures should be undertaken, if possible, to obtain
sufficient evidence.
Generally, if a matter were sufficiently important as to warrant a request for its inclusion in
the letter, a failure to obtain written representation would normally constitute a scope
limitation. This would result in the issue of an audit opinion which is either qualified except
for or for which a disclaimer of opinion is given.
In this case it should be reported by exception that in this respect all information and
explanations necessary for audit purposes have not been received.
(b) Management report
(i) Procedures
Timeliness
Communication of control weaknesses is normally made shortly after

completion of the audit. On larger engagements where control risk was
assessed during an interim visit, a letter should normally be sent after that
visit as well as on completion of the audit.
Occasionally the matter may be sufficiently serious that it warrants more

timely communication, such as where the exposure to risk is great or
where there is reason to suspect that fraud or failure to comply with laws
or regulations may already have occurred as a result of the weakness.
Method
As is implied in the title commonly given, the communication is normally

made in the form of a letter. Often, however, a preliminary meeting is
held with management directly responsible in order to confirm the
understanding and to discuss the most appropriate form of changes to the
system. The letter is, therefore, more likely to be accepted and its
recommendations acted upon.
Oral communication may also be appropriate for weaknesses that are in

urgent need of correction followed up by a written communication.
Level of management
It is common to discuss the detailed recommendations with line

management before issuing the letter. The letter would normally be
addressed to the finance director. The letter may refer to minor matters in
brief with more detailed recommendations being sent to financial officers
of divisions or subsidiaries.
1100
More serious matters may be communicated directly to the Board of

Directors or, if the entity has one, the audit committee. These would
include such matters as previous recommendations that have not been
implemented where the auditors believe the risks to the entity are material.
(ii) Auditors responsibility
The auditors are not primarily responsible for evaluating the effectiveness of all internal
controls and reporting all weaknesses. In the letter of weakness and in the engagement letter
the auditor should make it clear that the assessment of control effectiveness is restricted to
those controls on which reliance is intended to be placed for audit purposes. If auditors intend
to place reliance for particular financial statement assertions wholly on substantive
procedures, they have no responsibility for controls over those assertions.
Where the auditors do become aware of internal control weaknesses, however, there is an
expectation that they will warn management where the risk of loss or misstatement is
considered material. Awareness of control weaknesses may come about from procedures
other than those directed specifically at testing controls. For example, in obtaining an
understanding of the system the auditor may become aware of major control weaknesses.
Also, in performing substantive procedures, investigation of errors may alert the auditor to the
presence of control weaknesses.
The auditors duty to report on the effectiveness of internal controls, under auditing standards,
is confined to the management of the entity. They have no responsibility to report to other
parties. The letter of weaknesses normally carries a disclaimer of responsibility to any other
persons to whom the letter might be shown.
Auditors may accept engagements to report on control weaknesses, either to managers, to

regulators or to third parties. However, such engagements are not part of the audit of the
financial statements.
Answer 41 CRIGHTON-WARD
(a)
Management representations are a form of audit evidence. They are contained in a letter,
written by the companys directors and sent to the auditor, just prior to the completion of
audit work and before the audit report is signed.
Representations are required for two reasons:
Firstly, so the directors can acknowledge their collective responsibility for the preparation of
the financial statements and to confirm that they have approved those statements.
Secondly, to confirm any matters, which are material to the financial statements where
representations are crucial to obtaining sufficient and appropriate audit evidence.
In the latter situation, other forms of audit evidence are normally unavailable because
knowledge of the facts is confined to management and the matter is one of judgement or
opinion.
Obtaining representations does not mean that other evidence does not have to be obtained.
Audit evidence will still be collected and the representation will support that evidence. Any
contradiction between sources of evidence should, as always, be investigated.
1101
(b) Lions Roar
The amount of the claim is material being 50% of profit before taxation.
There is also a lack of definitive supporting evidence for the claim. The two main pieces of
evidence available are the claim from Lions Roar itself and the legal advice from Crighton
Wards solicitors. However, any claim amount cannot be accurately determined because the
dispute has not been settled.
The directors have stated that they believe the claim not to be justified, which is one possible
outcome of the dispute. However, in order to obtain sufficient evidence to show how the
treatment of the potential claim was decided for the financial statements, the auditor must
obtain this opinion in writing. Reference must therefore be made to the claim in the
representation letter.
Paragraph for inclusion in representation letter.
A legal claim against Crighton-Ward by Lions Roar has been estimated at $4 million by
Lions Roar. However, the directors are of the opinion that the claim is not justified on the
grounds of breach of product specification. No provision has been made in the financial
statements, although disclosure of the situation is adequate. No similar claims have been
received or are expected to be received.
Depreciation
This matter is unlikely to be included in the letter of representation because the auditor
appears to have obtained sufficient evidence to confirm the accounting treatment. The lack of
profit or loss on sale confirms that the depreciation charge is appropriate large profits would
indicate over-depreciation and large losses, under-depreciation. The amount also meets
industry standards confirming that Crighton-Wards accounting policy is acceptable.
Including the point in the representation letter is inappropriate because the matter is not
crucial and does not appear to be based on judgment or opinion. The only opinion here
appears to be that of the auditor unless the feelings can be turned into some appropriate
audit evidence, the matter should be closed.
(c) Lack of representation letter
The auditor may take the following actions:
Discuss the situation with the directors to try and resolve the issue that the directors have
raised. The auditor will need to explain the need for the representation letter again (and note
that the signing of the letter was mentioned in the engagement letter).
Ascertain exact reasons why the directors will not sign the letter. Consider whether
amendments can be made to the letter to incorporate the directors concerns that will still
provide the auditor with appropriate and sufficient audit evidence.
The discussion must clearly explain the fact that if the auditor does not receive sufficient and
appropriate audit evidence, then the audit report will have to be modified.
The reason for the audit qualification will be uncertainty regarding the amounts and
disclosures in the financial statements. An except for qualification for the material
uncertainty is likely, although a disclaimer may be required, especially if the legal claim is
thought to require a provision.
1102
Even if the letter is subsequently signed, the auditor must still evaluate the reliability of the
evidence. If, in the auditors opinion, the letter no longer provides sufficient or reliable
evidence, then a qualification may still be required.
Answer 42 RAVENSHEAD CONSTRUCTION
(a) Solicitors advice
Enquire into the background of the local solicitor and establish that he has no
connection with the company or with the officers of the company.
The auditor should investigate the experience of the solicitor ideally he should be
a specialist at this type of litigation.
The reputation of the solicitor should also be considered and his track record in the
past in advising the company should also be taken into account.
The information supplied for the solicitor and the correspondence with the solicitor
should be inspected; any opinions given by the solicitor should be from him in
writing and should not be merely the transcripts of conversation. The opinion of
any learned counsel briefed by solicitor is also relevant in this area. Lastly the
materiality of the amount of the claim should be considered and the solicitors
opinion should be read carefully. The solicitor may only give a very pessimistic
estimate of the likely outcome of the case. This should be considered in the light of
any precedence and will obviously be relevant in examining the accounting
treatment of the item in the financial statements.
(b) Independent valuer of investment properties
The independence of the valuer should be considered. He should have no

connection with the company or with any officer or director of the company. The
requirements of IAS 40 in this regard should be noted.
The qualification of the valuer should be noted. Membership of the/a national

institute for surveyors is a recognised qualification for this purpose.
The terms of reference given to the independent valuer should be noted. There may
be important reservations with regard to how the valuation is conducted. This may
obviously affect the quality of the valuers opinion.
The basis used for valuation must be reasonable and generally acceptable.
Investment properties are valued on the basis of the future income that they
generate. The calculations for the valuation should be examined and verified by the
auditor. This will involve communicating with the experts and establishing sight of
his working papers. The auditor should also consider the valuation of other
investment properties in a similar area with those contained within the portfolio of
his client.
(c) Internal valuation of construction contract
The value of the construction contract and the degree of monetary precision which
would be acceptable for its valuation.
The basis of valuation should comply with IAS 11 and should be consistent with
previous years.
1103
The accounting records for the contract should be reliable and should be capable of
substantiation.
The past record of the valuer should be considered; there should be other
construction contracts which have been completed in the past and the valuation
basis should have been capable of validation with the benefit of hindsight.
The auditor should also examine the estimate of cost of completion and estimated
contract revenue. The estimates of cost completion should allow for remedial costs
and for cost escalation in the price of materials. Any fixed price contract is likely to
be exceedingly risky. The auditor should check the calculation of attributable profit
and establish that all adjusting events after the reporting period have been taken into
accounts in the valuation of the contract. Where a loss is foreseen provision should
be made in full as per IAS 11.
Answer 43 SOUTHWELL ENGINEERING
(a) Test data
In using test data to check the operation of the companys accounting computer programs,
first I would either prepare some test files or copy the clients standing data and transaction
data files. Then I would print out these files, including the balances on each sales ledger
account and the total of the sales ledger balances. The purpose of printing the contents of the
files at this stage is to enable me to check that after input of the test data, the changes in the
contents of the files are correct.
Test data comprises valid and invalid data. Valid data should be processed correctly and with
invalid data either a warning should be given (for minor errors) or the data should be rejected.
First, I will input valid sales data comprising:
a valid account number

the current day for dispatch
various items to dispatch with the part number and quantity of each item.
I will check that the computer produces a dispatch note and a sales invoice in accordance with
these details, and updates the sales ledger. I will check that the correct prices have been used
on the sales invoice and that the calculations on the sales invoice are correct.
Invalid data will include:
an invalid account number. If the account number is not on the standing data file,
the computer should reject the data input. However, the computer will not reject an
account number which is for a valid customer, so the computer should display the
customers name and address on the screen so that the user can check that it agrees
with the details on the record from which data is being input
an invalid date could be input. If it includes alphabetic letters it should be rejected.

If it is for a date earlier than the current date, the computer should give a warning
and allow the data to be input again. If the date is some time in the future, a
warning should be given (ie it should accept a date up to a week in the future, if it is
up to a month in the future a warning should be given and if it is more than a month
it should be rejected)
1104
an incorrect part number can be input. This is similar to inputting an invalid

account number, as it should be rejected if it is not on the file. The computer should
display details of the part on the screen so that the user can check that it is in
accordance with the part number which has been input (ie the computer will not be
able to detect an incorrect part number, which is on the standing data file). The part
number may have a check digit to minimise the risk of an invalid number being
input. Also, it may comprise a letter followed by five numbers, and the computer
can have a format check to ensure the first character is alphabetic followed by five
numeric characters this format check can be tested by inputting invalid characters
(eg numbers where alphabetic characters are expected and vice versa)
the computer should not accept any alphabetic characters when the quantity is input,
and it should not accept zero or negative quantities. For most items it should only
accept whole numbers (as one cannot have half of a car!) but for liquids and solids
measured by weight or volume it may allow decimal figures. For some items, there
may be a limit of the quantity the computer will accept. The test data will be
designed to check these controls.
Following the input of this data, the listing of the invoices will be printed out, as well as the
sales ledger accounts updated and the total of the balances on the sales ledger. I will check
that the sales ledger accounts have been updated correctly and that the closing balance after
inputting the data is equal to the opening balance plus the value of the invoices posted to the
ledger. I will check that sales income has been recorded correctly and posted to the nominal
ledger.
(b) Computer audit program
A computer audit program can be used to select accounts for circularisation from the sales
ledger file using a random statistical sampling method. The most appropriate method to use
is monetary unit sampling, where the probability of an account being selected is proportional
to its value. A computer audit program can be used to perform this task.
The procedure for selecting accounts using monetary unit sampling is as follows. If the total
of the sales ledger balances is $1 million, and 50 accounts are to be circularised, one account
is circularised for every $20,000. First, the accounts are listed in account number order, and a
random number between 0 and 20,000 is selected (say 13,199). The following example
illustrates how this method is used:
Account name Balance Total b/fwd Total c/fwd Select?

$ $ $
1 AGJ 4,663 0 4,663 No
2 AHG 10,925 4,663 15,588 Yes
3 AKD 13,524 15,588 29,112 No
4 APD 17,236 29,112 46,348 Yes
5 ASG 241 46,348 46,589 No
Account 2 is selected because its balance straddles $13,199 (ie $13,199 straddles the b/f
balance of $4,663 and the c/f balance of $15,588), and account 4 is selected because its
balance straddles $33,199 (ie 13,199 + 20,000).
The computer audit program can be used to check the ageing of the account balances (as
described below), print out old outstanding balances and those over the credit limit. I will
circularise a sample of these balances which look doubtful. These will include accounts
where I am aware the company is in financial difficulties, and those where there are old
unpaid items. In addition, I may circularise a few zero value balances and credit balances.
1105
Using the list of accounts receivable I have decided to circularise (arrived at from the
procedures described above), the computer audit program will be used to write the letters to
send and include the balance in the letter. Also, a copy of the statement at the year end may
be included in the letter to enable the customer to identify the reasons for the difference
between his purchase ledger balance and the clients sales ledger balance. In addition, the
computer can send out second letters to customers who have not replied, analyse the results of
the circularisation and produce a statistical conclusion to this test (ie provide a quantitative
measure of the accuracy of the sales ledger).
(c) Year-end receivables
A computer audit program can be used on the sales ledger transaction file to:
add up the individual items on each sales ledger account and check that the total
agrees with the total balance on that account (normally, the computer stores the
individual items and the total balance on an account in separate data files)
check the ageing of sales ledger accounts and compare this ageing with that
produced by the companys normal accounting program
add up the balances on each sales ledger account and agree it to the total of the
balances on the sales ledger. The computer audit program can add up the individual
ageing of each account and check it to the total ageing, and it can calculate the
number of accounts with a balance and the total number of accounts on the standing
data file. The total number of accounts will be checked to the number printed by
the companys accounting computer program
the computer can print out sales ledger accounts where the customer is over the
credit limit or the debts are overdue. It can print out credit balances and those with
unallocated cash (ie where cash received has not been matched to sales invoices)
select accounts for circularisation, write the letters to the customers and analyse the
results (as described in (b) above).
Any differences between the figures calculated using the computer audit program and those
printed out by the companys normal sales accounting computer program would be
investigated.
The checks above will assist the auditor in the following audit tasks:
checking of the additions will be more comprehensive than the auditor could
perform manually. Once the computer audit program is set up, it will take very
little time to carry out with a consequent time saving in future years
checking the ageing of debts provides confidence that the companys age analysis
provides a reliable source of audit evidence
the overdue debts and those over the credit limit can be investigated to see if they
are doubtful debts. Credit balances often arise through errors (eg where invoices
are not posted to the sales ledger) and unallocated cash indicates weaknesses in the
companys system of control (as they should contact the customer and ask which
invoices are being paid and if there are any disputes).
1106
Answer 44 PETERSHAM
(a) Note to form the basis of a management letter
Tutorial note: Note in the last paragraph of the scenario, before the requirement, that this is to identify principal weaknesses, possible
consequences and recommended changes. So, for example, completeness of collection of the cards by the department supervisor is not a principal
weaknesses as any omissions would be promptly detected by the employees.
Principal weaknesses Possible consequences Recommended changes
Inadequate timekeeping Employees could record fictitious hours. Use properly designed time cards prepared
arrangements. in advance for each employee.
Use an automated time recording system.
Require supervisors to sign all time cards
as being correct.
No independent personnel function. Supervisors and wages clerk could add All personnel changes to be approved, in
fictitious employees to the payroll and writing, by the factory manager.
misappropriate their wages.
Restrict access to personnel data held on
the computer such that changes can only be
made by the factory manager.
Wages clerk should prepare a statement
reconciling net pay with the previous
weeks net pay. This should accompany
the copy of the weekly payroll and be
given to both the factory manager and
accountant.
No control over weekly payroll. Hours worked could be incorrectly entered. Reconciliation of net pay as above.
Accountant should periodically check the
payroll against personnel records and time
cards.
1107
Principal weaknesses Possible consequences Recommended changes
Poor control over cash drawn for Cash cheque could be misappropriated Use a security company to collect cash and
wages. either before reaching wages clerk or by the make up wage packets.
wages clerk.
Poor control over wages distribution. Supervisors could submit time cards for Wages packets should be delivered to
absent or terminated employees and collect accounts personnel with no payroll
their wages. functions and distributed jointly by that
staff member and the department
Employees could claim not to have been
supervisor.
paid.
Employees should be required to produce
identification and to sign for their wages.
Employees should not be allowed to collect
wages for others.
No procedure for unclaimed wages. Unclaimed wages could be misappropriated. All unclaimed wages should be returned to
the accounts department who should
reconcile unclaimed wages with the payroll
and with the list of signatures for collected
wage packets.
Unclaimed wages should be recorded in a
register.
Unclaimed wages should be rebanked if
not claimed within a couple of days.
Tutorial note: The Q clearly stated that a personnel department is NOT to be established therefore NO marks would be awarded to answer points
which contradicted this.
1108
(b) (i) Access and programmed application controls
Tutorial note: Manual controls (eg batch processing) instead of, or as well as, programmed
controls, were not asked for and accordingly attract no marks.
Access controls
Because of the sensitivity of personnel and wages records, data held on the personal
computer should be protected by passwords to prevent unauthorized attempts to
access sensitive data or to alter payroll data.
Knowledge of access codes to amend personnel information should be restricted to

the factory manager and a director. There should be a separate code for reading but
not amending personnel data that should, additionally, be known to the wages clerk.
Knowledge of access codes to the payroll program should be restricted to the wages
clerk and the accountant.
The computer used by the wages clerk should be networked with the factory
managers computer to enable the wages program to access up to date personnel
data when preparing the payroll.
Program controls
The payroll program could include edit controls as part of the weekly payroll run.
These should reject data entered by the wages clerk as follows:
Employee names (or numbers) not on the personnel file;

Weekly hours worked exceed 50;
Duplication of employee names (or numbers).
A further report (exception report) should be produced for director approval where:
Gross pay exceeds $500;

Hourly rate increase greater than 10%;
Employee names (numbers) on personnel file but not on payroll (to query
reasons for omission).
The personnel program should also include a control to prevent acceptance of a
wage rise greater than 10% entered by the factory manager. (The director also
having access to personnel records could have programmed access to override this
control.)
(ii) Test data
To confirm the correct operation of the program in calculating gross and net pay:
A set of test data using actual employees should be prepared from

personnel records (ie wage rates and deductions). The gross and net pay
for each and the totals for the week should be manually determined.
Typical hours worked for each of the employees should be inserted and a
printout of the payroll obtained for comparison with the manually
determined output.
1109
Data that would breach the program controls should be entered including:
fictitious and former employees;

hours in excess of 50; and
duplicate entries for the same employee.
In each case the computer should reject the entry.

To confirm the reasonableness test of $500 gross pay, personnel records should first
be amended to increase hourly wage rate to over $10 (otherwise the 50-hour limit
would prevent testing the operation of this control).
To test personnel records using the factory managers password:
routine changes to personnel data (ie additions, terminations and changes

in wage rates) should be entered to ensure the output is the same as
manually amended personnel data;
an increase in wage rates by more than 10% should be attempted to ensure

that the program control over such changes is effective.
These tests should be performed on copies of the programs used by the company to avoid
corrupting live data, particularly year to date totals. Reasonable precautions should be taken
to ensure that the copy is the version actually used by the company (eg by copying it
immediately after observing a payroll run by the wages clerk).
Answer 45 HYSON COMPUTERS
(a) Development expenditure ($500,000)
This development expenditure should be capitalised under IAS 38, provided the conditions of
IAS 38 are met. It can be seen that it is the use of scientific or technical knowledge in order to
produce new products so it qualifies as development expenditure
I will obtain from the company a schedule detailing expenditure on developing the system.
IAS 38 says that the development expenditure must be separately identifiable if it is to be
allowed to be capitalised. Normally this will involve development expenditure being posted
to a separate account in the general ledger. I will check that the expenditure relates to
developing the system described in as follows:
Any tangible non-current assets (computers, printers, scanners) purchased for
developing the system will normally be included as tangible non-current assets,
rather than development expenditure. Depreciation should be charged on these non-
current assets so as to write them down from cost to disposal value over the
development period. As the time to develop this system is quite short, it is probable
that the depreciation charge will be quite high, as the equipment will be bought new
and sold second-hand. The depreciation charge can be capitalised as development
expenditure, provided the non-current assets have been used only for developing the
new system. If they are used for other purposes, only the proportion of the
depreciation charge relating to developing the system will be debited to
development expenditure
1110
Purchases of software and other items for development of the software will be
checked to purchase invoices. I will test check large purchase invoices and a
smaller proportion of smaller ones to check than they relate to development of the
software
Labour costs incurred in developing software will be checked to the payroll. I will
check that the employees charging development expenditure either work wholly on
this development, or they have recorded their hours on time sheets and that the cost
of these hours has been charged to development expenditure. To confirm the
validity of this expenditure, I may ask the employees if they have been working on
the project
I will check that direct overheads relating to these wages costs have been correctly
added to development expenditure. Direct overheads will include employers
wages tax costs, pension contributions and holiday pay credit
I will check that other overheads added to development expenditure are reasonable.
Although IAS 38 does not specify how these overheads should be calculated, they
will probably be similar to production overheads, as described in IAS 2
(Inventories). They will probably include the costs of office accommodation for
development staff and a proportion of management costs
I will check other expenses charged to development expenditure. These will

probably include travelling costs, telephone, stationery and use of any computer
time for developing the system (eg use of a minicomputer)
Further costs, such as marketing and advertising the product will be checked to
purchase invoices, and I will consider whether it is appropriate to add these costs to
development expenditure.
Based on this work, I will decide whether $500,000 has been spent on developing the
software for this system.
(b) Capitalisation conditions
The conditions to allow the development expenditure of $500,000 to be capitalised are given
in IAS 38. The first matter I will consider is whether the system will operate as intended, and
reliably. In assessing this, I will:
get a member of the companys staff to demonstrate the system. They should be
able to show that the system can perform more than one task at the same time (eg
copying, while processing accounting data, or receiving a fax while performing a
word-processing task)
inspect reports from pilot users to check that they are satisfied with the system, and
that it operates reliably (ie it does not crash, or lose data). I will discuss any of the
users problems with the development staff, and assess whether they can be
overcome. I will ask for a demonstration of new versions of the software which
overcome problems experienced by users.
Based on this work, I will decide whether the system will prove reliable, and whether it will
prove attractive to potential users.
1111
Then, I will ask management for their predictions of sales, selling prices and the cost of
producing the product. In auditing this item, I will:
test check their calculation of future net revenues, based on predicted sales, selling
prices and costs
consider whether their sales estimates are realistic, optimistic or pessimistic. I will
look at enquiries the company has received about this software, and the number of
these enquiries compared with the publicity undertaken by the company. I will
check the percentage of enquiries which become actual sales for previous products
developed by the company. I will consider whether the product is likely to be
successful (this seems likely, as it should be a cheaper alternative than buying
separate faxes and photocopiers). I will consider whether a competitor may produce
a similar product, which will lead to a loss of sales. I will ask the companys
management if they are aware of any competitors developing a similar product, and
I will look at magazines and journals to check their representations. Printer
manufacturers already sell fax machines which can be connected to computers to
provide printing, copying and image reading facilities. I will consider whether the
product being developed by the company is likely to supersede these. Based on
these investigations, I will consider whether the sales estimate is realistic.
check that the selling price of the product is realistic, based on the selling price of
similar products. There is likely to be a structure of selling prices, with a higher
price for sales of single items and progressively lower prices for larger quantity
sales to customers (eg $500 a unit for sales of 1-9 units, $400 a unit for sales of 10-
99 units and $350 a unit for sales of over 100 units). I will consider whether the
mix of sales (in terms of small, medium and large orders) is realistic, based on
previous experience and the companys plans for selling this product
I will check that the costs of producing and selling the software are realistic. These
costs will include the cost of disks, copying the software onto the disks, and
preparing and printing the manuals and boxes containing the product. In addition, I
will check that the costs of marketing and advertising the product are realistic.
These costs will be checked to purchase invoices, and compared with the cost of
producing and marketing past products, with an allowance for the size of the
product (eg its development costs, selling prices and potential sales.)
Based on this work, I will decide whether the companys estimates of profits from future sales
of the product are realistic. Currently, it appears that there is a lot of price competition and
discounting of software products, and I will have to take this into account when estimating
future selling prices and sales (ie the future selling price may be lower than for past products
because of price-cutting).
The next matter to consider is whether the company can stay in business for sufficiently long
to sell the product. So, I will check future profit and cash flow forecasts of the company and
consider whether they are realistic. If development of this project is a very large item for the
company, the most adverse cash flow is likely to be at the start of sales to customers. When
sales commence, cash flow from sales should exceed costs (probably by a substantial margin).
Based on these investigations, I will decide whether the $500,000 of development expenditure
can be recovered against profits from future sales. If I am confident that this expenditure can
be recovered against future sales, I will give an unmodified auditors report. If I have
reservations about the recoverability of the development expenditure, examples of the forms
of auditors report I could use are given in part (c) of this answer.
1112
(c) Auditors report
(i) Recoverability of $500,000
If I have some uncertainties about the recoverability of the development expenditure, I will
ask the directors to explain the capitalised development expenditure in the financial
statements. My auditors report will then have a section which will refer to the uncertainty
about the development expenditure. This paragraph will end by stating that our opinion is not
qualified in this respect. Following this, it will have an opinion paragraph which will be the
same as for an unqualified auditors report. If the risk of the development expenditure being
worth less than $500,000 is very small, I may give an unqualified auditors report. However,
in view of the levels of litigation against auditors, many auditors would give an unqualified
auditors report with an explanatory paragraph, as described earlier in this paragraph.
(ii) Development is worthless
If my view is that it is not possible for the company to produce a commercially viable
product, then I will qualify my auditors report. The opinion paragraph will describe the
$500,000 development expenditure, and explain that in our opinion the capitalised
development expenditure is worthless, so it should be charged as an expense in the statement
of comprehensive income, reducing profit and net assets by $500,000. The next paragraph
will say that except for not writing off the development expenditure the financial statements
show a true and fair view. This will be an except for disagreement type of modified
auditors report.
Answer 46 WW
(a) Audit work on railway trucks
Examine board minutes authorising the purchase of the trucks (authorisation)
Cast the non-current asset ledger; agree total of railway trucks to the general ledger
and financial statements (completeness)
Ensure that railway trucks are actually stated as such in the non-current asset note.
As a material item, separate disclosure of this category is allowed (disclosure)
Cast the non-current asset note in the financial statements. Ensure the note agrees to
the amount disclosed in the statement of financial position (disclosure)
For a sample of assets from the ledger, confirm existence by physically seeing the
trucks (existence)
Identify the supplier of railway trucks from a purchase invoice. Obtain all invoices
from this supplier and confirm completeness of recording in the non-current asset
register (completeness). Also, during non-current asset inspection, record details of
some railway trucks and ensure those trucks are recorded in the non-current asset
register
Examine a sample of purchase invoices to confirm ownership of the trucks (rights

and obligations)
Review company policy for depreciation. As this is a new category of non-current

asset, obtain representation letter point regarding accuracy of amount. Confirm with
amount charged in similar companies that the depreciation percentage appears to be
correct (valutation and allocation)
1113
Agree depreciation charged in the non-current asset note to the amount on the
statement of comprehensive income (valuation and allocation)
Check a sample of depreciation calculations to ensure that they are accurate and that
they conform to company policy (valuation and allocation)
Ensure that any sales tax has been correctly treated e.g. capitalised where this is
non-recoverable (valuation and allocation)
Current value may also be confirmed using a specialist or appropriate trade journal
and compared to the net book value shown in the non-current asset register
(valuation and allocation).
(b) Issues to raise with management
Land and buildings
The depreciation rate has been correctly applied at 2% given an estimated life for the land
and buildings category of 50 years. However, the rate has been applied to the whole balance
that is land and buildings. In most companies, the value of land is not thought to decrease and
therefore depreciation is not appropriate.
To allocate depreciation accurately, a split is required between the land and buildings amounts
in the financial statements. Buildings will then be depreciated, but not the land.
Plant and machiner0079
Depreciation has been charged in full in the year of acquisition, but not charged at all in the
year of disposal. This appears to be an appropriate accounting policy charging depreciation
in the year of disposal would only amend the profit or loss on sale in that year and so have a
neutral effect on the financial statements..
There appears to be an error in the disposals calculation as the depreciation amount exceeds
the cost being eliminated There does not appear to be any logical reason for this situation and
it should be discussed with the directors to identify the reason, if any, for this treatment.
If an error is found, then the depreciation amount must be decreased (or cost eliminated
increased) and the profit or loss on sale amended accordingly.
Motor vehicles point 1
The depreciation percentage stated in the financial statements is 33%. However, the
calculation is either 25% on the year end balance or about 21% on cost brought forward and
additions for the year. To be consistent, the non-current asset disclosure note must agree to
the actual calculation in the non-current asset note.
The reason for the difference must be found and either the disclosure note or the depreciation
calculation amended If there has been a change in the depreciation rate, then this must also be
disclosed in the financial statements. There has not been a change in accounting policy the
policy of depreciation is unchanged, it is only the method of applying that policy that has
changed. There is no need to amend the prior year figures.
1114
Motor vehicles point 2
The cost and depreciation eliminated on sale are the same amount; this is not surprising given
that the assets were fully depreciated. However, the depreciation policy for motor vehicles is
to depreciate the category over three years. If those vehicles are now being kept for five years,
then the depreciation rate may need revising to show the actual useful life of the vehicles.
The depreciation rate needs to be discussed with company management, and if necessary the
rate amended to reflect the actual life of the vehicles.
Answer 47 SILVERHILL POTTERIES
(a) Basis for valuing inventory (IAS 2)
Inventory is valued at the lower of cost and net realisable value.
Cost is the purchase price (including import duties, transport and handling costs and
any other directly attributable costs) less trade discounts, rebates and subsidies.
For work in progress and finished goods of a manufacturer, the costs of direct labour
and production overheads, based on a normal level of activity, are included in the
value of inventory.
Net realisable value is the actual or estimated selling price (net of trade but before
settlement discount) less costs to be incurred in selling, distribution and marketing
(and for work in progress and raw materials, less all further costs to completion).
The valuation methods allowed under IAS 2 are FIFO (first in; first out) or weighted average
basis.
(b) Types of inventory which may be worth less than cost
Slow-moving and obsolete inventory.
Damaged and seconds inventory.
Inventory which is being sold below cost (eg in a sales promotion).
Also, it is desirable to check that categories of inventory with a high value at the year end are
being sold for more than cost (if they are being sold for less than cost, they should be valued
at net realisable value).
To identify such inventory
Obtain details of such inventory as recorded on the inventory sheets at the inventory
count, and in my audit working papers. Slow-moving inventory is likely to be dusty
(or the packaging dusty) and it may be stored in a different area from fast moving
inventory. It should be apparent if inventory is damaged. Seconds inventory may
be put in a different area, or it may be labelled seconds on the shelf where it is
kept. In addition, there may be odd items of pottery (eg some cups without saucers)
or incomplete sets which may be worth less than cost (some may be worthless).
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The computerised inventory records should note damaged and seconds inventory (ie
they should be in a different inventory category from perfect inventory). I will find
details of slow-moving inventory from the computerised inventory records. Some
pottery inventory may be held for long periods, but I will record inventory which is
over six months old as it is probably slow moving. Also, I will record apparently
fast moving inventory (cheap sets of pottery) which has been in inventory for over
three months, as it may be slow moving.
I will inspect sales reports, management reports and board minutes for further
evidence of inventory which may be worth less than cost. These reports should
indicate:
inventory lines which are being discontinued;

inventory which is difficult to sell or slow moving; and
damage to inventory.
Also, they will report special offers where inventory may be being sold for less than
cost. I will list details of such inventory which may be worth less than cost.
I will ask the appropriate management (eg sales director, storehouse manager) and
the directors if there is any inventory worth less than cost and I will record details of
such inventory. In particular, I will ask them if any inventory is being sold below
cost (eg in a sales promotion).
I will note the inventory items which I have recorded from the work described above and I
will check net realisable value as follows.
(c) Determining NRV
Net realisable value is:
the actual or estimated selling price; less

costs to be incurred in selling, distribution and marketing.
As Silverhill Potteries only has goods purchased for resale, costs to completion are not
relevant.
Determining actual or estimated selling price
If all the inventory has been sold between the year end and the date of my checks, I will check
the selling price to sales invoices issued after the year end (the selling price is after trade
discount but before settlement discount). If most of the year end inventory has been sold by
the time of my check, then the selling price after the year end will be used for that inventory.
If there have been few (or no) sales after the year end, I will check sales invoices selling the
inventory before the year end. This will be the best estimate of the price the inventory will be
sold for after the year end. However, if the inventory has become obsolete between the last
sale before the year end and my audit check, then the selling price before the year end may be
too high compared with the price the inventory will be sold for after the year end. So, I will
have to consider a fair price this inventory will be sold for after the year end (this will be the
estimated selling price).
1116
If there have been few sales before and after the year end, the inventory may have to be sold
at a very low price to provide space for new inventory. If the value of this inventory (at cost)
is significant, I will have to check the companys plans for disposing of it. Overall, it is
probably wise to estimate a very low selling price.
Some damaged inventory items and odd items (eg single cups without saucers) may be worth
only scrap value, and I may accept that they should be included in inventory at zero value.
It should be noted that it is unreliable to determine the selling price from the companys price
lists, as this type of inventory is probably being sold at a lower price than that shown on the
price list.
I will compare my estimates of selling prices with the companys. I will discuss cases where
there are significant differences between my estimates and the companys, and I will discuss
with them situations where I find it difficult to estimate the selling price of the inventory (eg
for incomplete sets, and very slow-moving inventory). Based on these discussions I will
consider whether the managements estimates of the selling prices of the inventory are
reasonable.
These checks above will have determined the actual or estimated selling price. Net realisable
value is found by deducting costs to be incurred in selling, distribution and marketing from
this selling price.
Generally, selling, distribution and marketing expenses are small, so I will find the years
selling, distribution and marketing costs and total sales from the general ledger. I will
calculate the ratio of selling, distribution and marketing costs to total sales for the year (say it
is equal to 4%). Using this figure, net realisable value will be 96% of the actual or estimated
selling price.
If it is apparent that some inventory items will incur larger selling, distribution or marketing
costs, then the actual costs would be deducted from the selling price to determine net
realisable value. For instance, if the items have to be exported then the carriage costs will be
high.
From these investigations, I will determine the net realisable value of the inventory:
Assuming I have found the cost of the inventory, I will value the inventory at the lower of
cost and net realisable value. Then I will compare my inventory value with the companys. I
will discuss any significant differences with them, and I will note any significant
disagreements in my schedule of unadjusted errors.
Answer 48 TRENT TEXTILES
(a) Prior to the commencement of the inventory count
Review last years audit working papers and note the companys system for
carrying out the inventory count and any problems experienced last year.
Ask the companys management the date the inventory is to be counted.
Ask for a copy of the companys instructions for physically counting the inventory
and checking that it will ensure the inventory is counted accurately.
Check that the staff counting the inventory have been provided with the instructions
before the inventory count.
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Note if any inventory is being held by third parties. If inventory is held by third
parties, I will ensure that I have adequate evidence to confirm the existence of this
inventory. If the value of this inventory is small, confirmation by the third party
will be adequate. If it is material, I will probably have to attend the inventory count
at the third party.
If there were problems with the inventory count last year, I will inform the
companys management of these problems and ask that staff carrying out the
physical count are aware of them so that they will not recur this year.
(b) Procedures to ensure accurate recording of inventory
Ensure that the staff have been briefed by the companys management prior to the
physical count, and that they are aware of the inventory they are required to count.
Inventory sheets should be sequentially numbered, and an employee should be

responsible for recording the issue and return of inventory sheets. At the end of the
count this employee should ensure that all the inventory sheets have been returned
by the counters, and that there is a record of the inventory sheet numbers used.
Inventory quantities and descriptions should be recorded on the sheets with a pen,
and any changes should be initialled by either the staff counting the inventory or the
manager in charge of the inventory count. The staff counting the inventory should
sign the bottom of the inventory sheets, and any incomplete inventory sheets should
be ruled off so that no more items can be added (after the inventory count).
Ideally, staff should not count inventory which they are responsible for, as this
represents a weakness in the system of internal control. However; staff who are
responsible for the inventory are likely to describe and count it more accurately than
other staff. If staff count their own inventory, there should be more supervision and
checks by management to ensure it is counted accurately.
Staff should count the inventory systematically; by, for instance, going from left to
right along shelves. Inventory should be marked when counted to ensure it is
counted once and once only. Staff should count the inventory in pairs, with one
employee counting the inventory and the other recording the descriptions and
quantities on the inventory sheets.
As Trent Textiles is a manufacturer, it is important that the inventory sheets

accurately record the description of the inventory and its state in work in progress
(eg knitted arms of garment 123). If any employee has difficulty in identifying the
inventory, he should consult the manager in charge of the inventory count. For
simplicity in counting, it may be appropriate that inventory which is being knitted is
counted as half a knitted part; and balls of wool on knitting machines are counted as
being half full. For inventory like balls of wool; it is important the weight of the
inventory is correctly determined.
Staff should record the condition of slow-moving, damaged or obsolete inventory

on the inventory sheets. This is important, as it indicates inventory which may be
worth less than cost, and it may be the only way I can highlight this inventory at the
final audit.
There should be no movement of inventory during the physical count, as this could
result in the inventory not being counted or being counted twice.
1118
Management should perform test counts, and check these counts to those counted
by the staff counting the inventory. Any significant differences should be
investigated.
At the end of the count, management should ensure that all inventory has been
counted, by randomly selecting inventory items and finding the quantities on the
inventory sheets.
Management should record the last numbers of documents prior to the inventory
count of:
goods dispatched (ie last shipping note number);

goods received (ie last receiving report number) returns to suppliers;
returns from customers.
(c) At the inventory count
To confirm that the inventory count is being carried out in accordance with the
clients procedures I will check:
Inventory is counted systematically
The inventory is marked when counted
The counting is performed carefully
There is a proper description of the items on the inventory sheets,

including their description and state of completion
Inventory which is slow moving, damaged, obsolete and seconds is

properly recorded on the inventory sheets
There is no movement of inventory during the physical count.
I will perform a sample of test counts, concentrating on large value items. These
checks will be performed:
From the inventory sheets to the physical inventory, to ensure that

inventory on the inventory sheets exists
From the physical inventory to the inventory sheets; to ensure that all
inventory which exists appears on the inventory sheets.
I will record details of these test counts in my audit working papers. These details
will include a description of the item, its part number and quantity, and the
inventory sheet number on which the count is recorded. I will put a mark on the
inventory sheet so that the item can be identified at the final audit.
Any errors found in these counts will be discussed with the staff counting the
inventory, the inventory will be counted again, and the correct quantity will be
recorded on the inventory sheets and in my audit working papers.
Where inventory is recorded by weight, I will check that the companys procedures
correctly determine this weight, and I will test check the weight of a sample of these
items.
1119
If there is any inventory in sealed boxes, I will ask for a sample of these boxes to be
opened, so that I can ensure that they contain the garments (or other items) stated on
the note on the box. For a further sample of boxes, I will check their weight to
ensure they are likely to contain the quantity stated on the note on the box.
I will record:
The inventory sheet numbers used. Sometimes the client will copy the
inventory sheets at the end of the count, and I can keep a copy in my audit
working papers. This will highlight any additions or amendments to the
inventory sheets and any inventory sheets which have been added at the
end of the count.
Details of the last numbers before the inventory count recording:
dispatch of goods
receipt of goods
returns from customers
returns to suppliers.
At the end of the inventory count, I will check that all the inventory has been
counted, by test checking that items in the factory are recorded on the inventory
sheets. I may test check items on the inventory sheets exist by checking from the
inventory sheets to the physical inventory (note that this check has been performed
in part (c) above).
I will complete my audit firms checklist relating to the inventory count.
I will note any errors and weaknesses I have found during the inventory count, so
that they can be followed up at the final audit.
Answer 49 PERPETUAL AND YEAR-END INVENTORY COUNTS
(a) Importance of inventory counting
Inventory counting is important to auditors of manufacturers, wholesalers, retailers

and many service organisations. Inventory counting is the best way to establish
quantities for valuation purposes and it assists management in making appropriate
provisions against obsolete, slow moving and damaged items.
Inventory counting provides the only direct evidence in relation to the existence of
inventory. Performed properly, counting also provides evidence on cut-off, certain
frauds and on the quality of internal controls over inventory.
Auditors should attend inventory counts where inventory is material to the financial
statements (statement of financial position or statement of comprehensive income).
1120
(b) Perpetual inventory system
The purpose of a perpetual inventory system in practice is to control inventory.

Such a system involves cyclical counting procedures during the year. Such
procedures avoid the need for reliance on a year-end count. If auditors wish to rely
on the records rather than a year-end count for the purposes of the financial
statements they must ensure that the cyclical counting procedures are adequate and
are being properly and consistently applied, particularly in a large dispersed
organisation.
I would ensure that all inventories had been counted at least once a year and that the
records had been kept up to date and were promptly corrected for any discrepancies
discovered as a result of counting.
I would assess the risk attaching to the different locations and seek to visit those
locations where the value or volume of inventory is substantial, and where controls
are weak (i.e. where risk is greater).
It may be necessary to involve other offices of my firm, or to engage staff from

another firm to attend counts, and to co-operate with internal audit, who may wish
to conduct their own counts (on which I may wish to rely), or who may lend staff to
my firm.
If using other firms of external auditors, and relying on internal audit work, it is
particularly important that I am satisfied with the quality of that work and that my
involvement is sufficient for my firm to be able to justify its audit opinion.
My firm may perform visits on a rotational basis throughout the year to ensure
adequate coverage of all locations.
(c) Weaknesses in counting instructions why they are difficult to overcome
Weaknesses Why difficult to overcome
The date of the count may be inappropriate These problems are difficult to overcome
staff (and auditors) will not wish to work on a because the shop and warehouse are open
public holiday and given that there is a high seven days a week and because it is
level of staff turnover, there is a possibility expensive and difficult to obtain others (who
that staff will not arrive or will complete the may not be appropriately experienced) to
work too quickly without properly counting perform the count.
the inventory. This is compounded by the fact
that staff are working individually and may It might be suggested that the count be
make errors or attempt to cover up conducted, say, a week before or a week later
misappropriations. and that a roll-forward or roll-back be
performed, but this will cause additional
There may be insufficient time allowed to staffing problems and problems with the
prepare the inventory for counting and it is movement of inventory. It may be difficult
likely that the shop and warehouse will be for the company to change its year-end
untidy because the business has been busy. because of local regulations. Some of the
managers might be asked to come and help.
1121
Too much responsibility is in the hands of Mr This is difficult to overcome because family
Sneg (a lack of segregation of duties). He is owned companies, (even large ones) often
responsible for the assets (the inventory), the place a substantial amount of trust in valued
records, the staff and the adjustments to the employees who would be offended if it were
records. suggested that it were necessary to check
their work in some way.
It may be necessary for Mr Sneg to be
involved with the count but he should be
responsible together with another
representative of management who is not
involved with the day-to-day control of
inventory (such as the finance director). It
will be too easy for Mr Sneg to hide errors or
falsifications in the inventory records to cover
up errors or misappropriations.
It would be particularly easy for him to falsify

records in relation to, for example, inventory
in stock but already sold and inventory
delivered but not yet paid for.
The add-back of inventory delivered but not

yet paid for appears to be wrong, as a matter
of principle, even if the related invoices are
removed from the revenue accounts.
Answer 50 ROCKS FOREVER
(a) Audit procedure Physical count Reason for procedure
Perform an overall review with client staff Check that clients physical count
ensure that they are following the clients instructions are being followed as this will
physical count instructions. Specifically help to ensure that the count is complete and
ensure that: accurate.
Inventory is divided into appropriate Confirms a clear layout of inventory
sections for recording perhaps by ensuring items are not missed.
type of jewellery.
Staff are counting in pairs with one Prevents collusion and provides a
person checking the inventory and check over security of inventory
another recording details. (jewellery is high value) and that the
count sheets are not falsified.
Appropriate checks are in place to Check to ensure that inventory is not
ensure that each item of jewellery is double counted.
only counted once.
The shop is closed during the count. To ensure that there is no confusion
regarding which items are sold.
Countsheets are pre-numbered. To ensure that no count sheets are lost.
1122
Obtain a sample of inventory items already Check to ensure that the inventory recorded
recorded on the inventory sheets and agree on the inventory sheets actually exists.
to the jewellery inventory.
For a sample of jewellery in the shop, agree Check to ensure that all inventory is
to the count sheets. recorded on the inventory sheets check for
completeness of recording.
Obtain a sample of countsheets, photocopy To check that details on the count sheets are
and place on the audit file. not amended post physical count and for
agreement to the final inventory sheets to
ensure quantities are recorded correctly.
Check all countsheets are returned after the Ensures that all sheets are accounted for and
physical inventory count. inventory is therefore not understated.
Obtain last inventory receipt note and sales To ensure that cut off is correct.
invoice numbers.
Subequent checking should show that goods
received notes post physical count are not
included in payables for the year, and sales
invoices after the physical inventory are not
included in sales for the year.
Review the condition of the jewellery with To check that any inventory which is
the independent valuer. Ensure that there are damaged or unsaleable is correctly valued.
no reasons why the inventory could be
obsolete (e.g. due to changes in fashion) or
damaged.
Form an opinion regarding the overall To confirm that inventory quantities have
accuracy of the physical count. been correctly recorded.
(b) Factors to consider when placing reliance on the work of UJ:
DeCe need to confirm that they actually need an expert. It is not clear whether DeCe have the
necessary skills in-house. However, given that Rocks Forever is the only client in the
diamond industry, then some assistance would be expected as valuing diamonds is difficult.
Check that the specialist has relevant experience in valuing diamond jewellery. Part of the
appointment process will include checking the work portfolio of UJ to show that they have
valued diamonds in other situations.
Ensure that UJ is a member of an appropriate professional body. This will help ensure that UJ
follow the appropriate ethical standards as these will be enforced by their professional body.
Check that UJ cannot be influenced by the client for example because they are employed by
Rocks Forever. Being employed by the client would imply less independence and limit the
value of the specialists report.
Check that the report produced by the specialist regarding the valuation of the diamonds
appears to be reasonable. Although DeCe do not have any other clients retailing diamonds,
basic price comparisons for a given weight of diamond could still be obtained from other
shops or Internet site to prove the accuracy of UJs figures.
1123
(c) Audit evidence
The jewellery inventory should be valued at the lower of cost and net realisable value.
For a sample of jewellery on the final inventory sheets, trace the cost of those items to the
original purchase invoice, ensuring that the description of goods on the invoice matches the
jewellery.
For jewellery sold after the end of the year, check a sample of sales invoices back to the final
inventory sheets ensuring that the sales value exceeds the cost. Where sales value is less than
cost, ensure that the jewellery is stated at the realisable value on the inventory sheet.
Review the report of the professional valuer. Ensure that the inventory is genuine. For the
items checked by the valuer, agree the valuation to the items of jewellery on the inventory
statements. Where there is a difference, for example due to age of the inventory or where it is
unlikely to be sold due to changes in fashion, discuss with the client and agree a realistic
valuation.
In these situations, the value should be that provided by the professional valuer.
Where an item has been in inventory for a long period of time (perhaps over one year), check
the valuers report to find out whether any allowance is required.
Answer 51 GOODFOOT
(a) External confirmation
(i) Positive and negative confirmations.
Negative confirmations request a reply from the debtor only if the debtor disagrees with the
amount. Positive confirmations request a reply in any case. Negative confirmations are
generally only used with a representative sample of a large number of small accounts where
internal controls are strong.
(ii) Positive confirmations.
There are two types of positive confirmation. In the first type, the amount owed is stated by
the client and the debtor is asked to agree or disagree. If the debtor disagrees, he is asked to
provide an explanation of why he disagrees in the form of reconciling items. In the second
type, the debtor is asked to fill in the balance. The advantage of the first type is that the debtor
may perform the reconciliation. The principal disadvantage is the fact that the debtor may
simply agree with any amount stated, particularly if it is understated. With the second type,
the debtor is less likely to reply as more work is involved, but the amount stated represents
what is in the debtors records. It is not possible for the debtor to perform the reconciliation in
this case.
(iii) Reconciling items.
Reconciling items include: cash, goods and credit notes in transit and other timing
differences, debit notes, contras, journal entries, disputed items, and simple errors on the side
of either debtor or supplier.
1124
(b) Financial statement assertions receivables
Assets are generally more at risk from overstatement than from understatement. There is a
risk that receivables are overstated by the under-provision for bad debts. If assets are
overstated, profits are likely to be overstated and it is therefore sometimes tempting to under-
provide for bad debts in order to show a better profit figure, as well as for management
purposes.
Bad debts can sometimes be hidden by the use of credit notes and similar devices; whilst this
does not affect the overall profit figure, it can affect the presentation of the financial
statements.
(c) Audit work on receivables and bad debts
Comfort can be taken from the proper operation of internal controls over receivables
and it is therefore possible to reduce the level of substantive testing.
The primary focus of substantive testing will be the external confirmation. A 50%
response rate is quite adequate. All of the thirty largest accounts can be circularised
together with a representative sample of the remainder, paying particular attention
to old accounts, nil balances and credit balances.
For those accounts where there is no reply, and for any other accounts selected for
testing it will be necessary to gain comfort on the amount receivable by reviewing
cash received after the period end. Where cash has not been received, it will be
necessary to review signed delivery notes, contracts, the pattern of payments, etc.
For accounts confirmed, any differences should be thoroughly investigated and

followed up, with the help of the client if necessary. It should be remembered that
where a debtor agrees that an amount is owed, it does not automatically follow that
the amount will be paid.
The bad debt provision should be reviewed in the light of past experience and
current period conditions. Generally, specific provisions are permissible for tax
purposes but not general provisions and the tax computation should be checked.
The arithmetical accuracy of the ledger should be checked as should the correct
presentation of the amounts in the financial statements.
A review of invoices and credit notes around the period-end may highlight the need
for additional provisions.
Analytical procedures on the ageing of debtors by comparison with prior periods

will give comfort on bad debt provisions.
Sales cut-off testing should be performed to ensure that amounts have been
correctly recorded in the correct period.
1125
Answer 52 LIDCOMBE
(a) Accounts receivable circularisation
From arrival at Lidcombes premises
Obtain a copy of the aged listing of accounts receivable. To ensure that the sample
to be circularised is selected from an accurate representation of accounts receivable
he must verify the existence, completeness and valuation of the individual accounts
by:
test vouching individual balances from the accounts receivable ledger to

the listing;
test tracing individual balances from the listing to the accounts receivable
ledger;
testing the ageing of a sample of accounts;
adding the listing and agreeing the total to the accounts receivable balance
in the general ledger.
Scrutinise the list of balances for unusual items such as substantial credit balances
and round sum payments on account which may need to be selectively tested
separately from the circularisation.
Determine the sample selection criteria (eg individually material balances may be
selectively tested and the remaining accounts divided into a population of current
due and a population of overdue balances).
Determine sample size having reference to the planned level of detection risk and
tolerable error.
Select the sample using an acceptable sample selection method such as the use of
random numbers or systematic selection.
List the accounts selected and present the list to an authorised company official for
the confirmation requests to be typed up on Lidcombes letterhead and signed by
the officer authorising customers to supply the auditor with the information
requested.
Check the confirmation requests to ensure that there is a letter for each account
selected and that the stated balance is correct to ensure that Lidcombe has not
attempted to change any of the selected accounts. If appropriate, ask management
why they have withheld permission to confirm certain accounts, record the
discussion on a working paper and, if the explanation appears unreasonable, bring it
to the managers attention. Perform alternative procedures to verify those accounts
for which permission to confirm is withheld.
Post the requests in envelopes bearing the auditors return address. They must not
be given to Lidcombe to post since this provides a further opportunity for
confirmation requests to be suppressed. Using the auditors return address ensures
that any that are non deliverable are returned to the auditor, since the collectability
of such accounts is doubtful.
1126
Prepare a working paper setting out the total accounts receivable, the basis for
determining sample size and for selecting individual accounts for circularisation.
List accounts confirmed on a schedule noting the date of first confirmation with
columns for recording the date of second request, amount confirmed and details of
any investigation of differences.
(b) Use of CAS in confirming accounts receivable
To test the accuracy of the accounts receivable ledger by:
checking postings to the ledger from sales and cash receipts records;
ensuring that the accounts receivable system is reliable so that the age of
outstanding balances is correctly determined;
testing the accuracy of additions of individual balances.
This will probably have been undertaken at the interim audit.
To cast the listing of accounts receivable and agree the total with the balance on the
general ledger.
To identify unusual items (eg large credit balances or round sum payments on
account or credit notes processed after the year end) for consideration for selective
testing.
To select accounts for circularisation by programming in, either the number to be

selected and the selection criteria, or by specifying the statistical sampling plan to
be used, and entering required data such as detection risk and tolerable error.
To print out confirmation requests for each account selected.
To prepare a working paper listing selected balances.
To analyse responses in accordance with the sample plan and determine the
statistical error rate.
To calculate key ratios (eg average collection period/days) to provide additional

evidence concerning the accuracy of the aged-debt analysis.
(c) Review of Marys working paper matters raised
There is no objective for the audit test recorded on the working paper.
Determination of sample size is not given such that it can be seen to be sufficient for
drawing conclusions as to the population.
It is not clear whether the population has been stratified or otherwise subdivided in
selecting the sample.
20% is a relatively small proportion of ledger balances (also 5 out of 90 balances is

less than 6%). This does not appear to be adequate for a test of overstatement.
1127
120,000 24,370
The average balance on accounts not tested is > $1,000 ( = 1,125)
90 5
therefore it seems likely that there will be other balances > $,2,500 that should have
been tested.
The method of sample selection is not stated. This is necessary if the sample is to
be evidenced as representative of the population.
There is no indication of the age of the balances tested.
Note 1:
Since this is already a sample, the testing of the balance should be

complete, rather than a sample of the invoices that make up the balance.
The copy invoice is not persuasive evidence as to the existence of the debt
as it is purely internal. Mary should sight documentation originating from
outside the company, such as the customer purchase order, or circulated
outside the entity, such as a copy of the delivery note signed by the
customer.
This provides no evidence as to valuation. Mary should also have looked

for a subsequent receipt of cash.
The extent to which this a/c has been verified is not quantified. As this is
considerably less than $20,000, Marys coverage of accounts receivable is
much less than 20% (perhaps only 5%).
Note 2: Details of evidence sighted should be noted, eg:
Correspondence between Lidcombe and Ray, and Lidcombes comments

on the matter, so that a judgement may be made as to collectability.
Goods return note and whether Mary inspected goods returned.
Whether a credit note has been issued after the year end.
Whether Lidcombe is continuing to supply Ray with goods.
Note 3: This is the best form of evidence to confirm the existence of accounts
receivable. Mary should also have tested for payments received after the year end
to verify valuation.
Note 4: This is an amount that correctly should be in the summary of audit

differences. Further work may be necessary on credits issued after the year end.
Note 5: The work on this balance is adequate.
There is no conclusion as to whether or not the evidence supports the recorded

balance.
1128
Answer 53 BARDWELL LTD
(a) Internal control procedures
(i) Inadequate segregation and proposed reassignment
A basic principle of segregation of duties is that an individual employee should not be able to
make errors and be in a position to conceal the fact. Proper segregation means that, if an error
or misstatement is made, it will be detected by another employee in the ordinary course of his
or her duties. A general rule of segregation is that the functions of processing transactions,
recording transactions and maintaining records over the subsequent assets or liabilities,
should be performed by different individuals.
The receptionists duties should be restricted to processing cash receipts transactions. All
other functions should be assigned to other staff members.
1129
Function to be reassigned Possible misstatement Reassignment
Checking the numerical The receptionist could deliberately understate the total in order to This should be assigned to clerk 1. (See
continuity of invoices, misappropriate the cash or conceal a shortage of cash. other procedure 1.)
determining the total cash
sales and entering the cash
receipts journal.
Posting the sales ledger. An invoice could be deliberately omitted and the subsequent cash Clerk 1 should post the sales ledger from
receipt misappropriated if done by the same person. credit sales invoices whose numerical
sequence is checked.
Errors, such as transposition errors, made in entering the sales journal
are likely to be repeated in entering the sales ledger.
Cash receipts could be temporarily misappropriated and the shortage
concealed by delaying recording the receipt.
Sending out monthly If there are errors in the sales ledger the monthly statements could be
This function should be assigned to clerk 2
statements and chasing altered or suppressed. since clerk 1 could also falsify statements to
overdue accounts. conceal errors in recording sales in the sales
If payments by customers have been misappropriated and not credited
ledger. (See other procedure 2.)
to the customer account, customers suspicions would not be aroused
by chasing apparent overdue balances.
Reconciling receivables This procedure detects errors, deliberate or accidental, in the Clerk 2 should perform the reconciliation as
with the control account in maintenance of trade receivables records. If the receptionist has having no responsibility for recording either
the general ledger. made errors in processing sales and cash receipts transactions to cash or sales transactions or maintaining the
customers accounts then he would have an incentive to conceal their sales ledger. (See other procedure 3.)
discovery by falsifying the reconciliation.
Writing off uncollectible If errors have been made resulting in an understatement of cash Clerk 2 should advise the manager of
balances. received from credit customers, their accounts will appear overdue. overdue balances that may need to be to be
This can be concealed by writing off the balance. Deliberate written off. (See other procedure 4.)
misappropriation of cash receipts could similarly be written off.
1130
Answer 54 BANK & CASH
(a) Errors and misappropriations cash
(i) Receipts
Money paid into the bank may be stolen. If cash is not properly controlled it is
possible to falsify documentation in relation to receivables, and to pay company
receipts into private bank accounts. This is sometimes known as teeming and
lading.
Money paid into the bank may be incorrectly accounted for, either by the bank or by
the company, if there are no controls to check the accuracy of the companys
records or the bank statements. This could mean that the internal records and the
financial statements are incorrect.
(ii) Payments
Money paid out of the bank may be paid to incorrect suppliers, or may be paid for
incorrect amounts resulting in operational difficulties with cash and supplier
management.
Money paid out of bank accounts may also be misappropriated by payments for
goods and services that are not received, or simply by payments into private bank
accounts if there are no controls to prevent this.
(iii) Interest and charges
Banks make errors in calculating interest and charges. If the company does not
check these, it may lose money and the amounts appearing in the financial
statements may be incorrect. This is particularly important for companies that hold
high levels of cash.
(b) Principal audit objectives of cash audit and related audit evidence
Audit objectives are dealt with in ISA 500 Audit Evidence
Existence: to ensure that the cash actually exists at a given date. The related
evidence will include cash counts. Cash counts need not necessarily be conducted at
each location (unless the amounts are material), the firm might consider conducting
counts on a rotational basis, year on year. If it is necessary to conduct counts at all
locations, it may be possible to use the offices of another firm of auditors (with the
permission of the client). The decision as to which sites to visit might be determined
on the basis of materiality and analytical procedures. Cash balances should be
reconciled to records held at the shop and records held at head office. Any shortfalls
in cash, or IOUs1 should be thoroughly investigated.
Completeness: to ensure that there is no unrecorded cash. This means reconciling

cash balances to records held at the shop and records held at head office, as above,
ensuring that proper sales cut-off has been achieved.
1
I Owe You where cash has been taken without proper authorisation.
1131
Rights and obligations: to ensure that the company has a right to the cash. This
means checking to ensure that credit card vouchers are correctly made payable to
the company, and not to third parties.
Occurrence: to ensure that the cash belongs to the company at the year-end date.
This means checking to ensure that no credit card vouchers are post-dated.
Measurement: to ensure that amounts are correctly recorded in the proper period.
This means ensuring that cut-off is correct and consistent between the records held
at shops, the returns to head office, and the records held at head office.
Presentation and disclosure: to ensure that the cash balance and related statement of
comprehensive income entries are correctly disclosed in the financial statements in
accordance with legislation and accounting standards.
(c) Why auditors seek bank confirmations matters confirmed
This matter is noted in ISA 505 External Confirmations.
Auditors seek bank confirmations in order to provide third party, written evidence in relation
to the statement of financial position disclosure of cash, liabilities and related items.
The matters typically confirmed by the bank include:
Details of all bank balances, overdrafts and loans held at all branches.
The charges or restrictions over any such accounts.
The terms and repayment conditions of loans and overdrafts.
Any right of set-off between accounts in credit and other balances.
Any securities held by the bank (such as mortgage documentation).
Any relationships with other banks the bank is aware of.
Additional information such as details of trade finance and derivative instruments

(such as foreign exchange contracts, options, futures and swaps).
Answer 55 RAVENSHEAD ENGINEERING
(a) Suppliers statements
I will assess the system of control in the purchases system and its reliability. This
will be based on the results of my tests of control, other investigations and my
experience in previous years. Where the purchases system is reliable, I will check
fewer items than if it is unreliable. If I find discrepancies in my audit tests, I will
increase the sample of items I check. I will check fewer suppliers statements to the
purchase ledger balances if a member of the companys staff regularly performs
these checks and corrects discrepancies.
Generally, I will check a larger proportion of suppliers where the balances are large,
or where there are a large number of transactions. Where there is no suppliers
statement for one of these important accounts, I will either contact the supplier to
confirm the balance, or ask for a statement at the year end (this could be sent by
fax).
1132
Where the balance on the suppliers statement is the same as the purchase ledger
balance, I will record the agreement in my audit working papers and carry out no
further work on that balance.
Where there is a difference, I will divide it into:
goods in transit
cash in transit
other differences.
Goods in transit are invoices on the suppliers statement which are not on the
clients purchase ledger. If these differences have been included in purchase
accruals, I may perform no further checks. However, for large value items, I will
check the goods received note (GRN) to ensure they were received before the year
end. If there is no purchase accrual, I will check the date on the GRN. If the date
on the GRN is after the year end, the treatment is correct. However, if it is4 before
the year end there is a cut-off error, and the value of these goods will have to be
included in my schedule of unadjusted errors.
For cash in transit, I could check to the next months suppliers statement that the
cheque was on the suppliers sales ledger just after the year end. An alternative is to
check to the bank statement the date the cheque is cleared by the bank after the year
end. If there is a significant delay in clearing the cheque (and this is common to a
number of cheques issued immediately before the year end), this indicates that the
cheques were sent to suppliers after the year end. If this has been happening, the
value of these cheques should be deducted from the year end bank overdraft in the
draft financial statements and added to payables at the year end (as the payment did
not occur until after the year end).
For other differences, if they are small, they can be ignored. However, if they are
significant I will discuss them with the client and I may ask if I can contact the
supplier to confirm the reason for the difference. The year end accounts should
include an appropriate provision to allow for such differences (generally, this should
be the difference between the balance on the suppliers statement and that on the
clients purchase ledger).
Based on these tests, I will assess whether they provide sufficient evidence that
accounts payable and purchase accruals are correctly stated at the year end. If,
because of errors I have found, I believe I have not obtained sufficient reliable
evidence, I will increase the number of purchase ledger balances I check against
suppliers statements.
(b) Purchases cut-off
The best place to start a purchases cut-off test is from goods received notes issued
immediately before and after the year end. Generally, the test should cover a sample of items
during the period two weeks before to two weeks after the year end, concentrating on larger
value items: More items are likely to be selected from before the year end than after the year
end, as there is a greater risk of cut-off errors with these transactions.
At the inventory count, I should have recorded the last goods received note number issued
before the year end (eg number 1462). Goods received before the year end should have a
goods received note number of 1462 or less and goods received after the year end should have
a goods received note number of 1463 or more.
1133
I will select a sample of goods received notes issued before the year end, and follow through
to the purchase invoice. For these goods I will check that:
either the purchase invoice has been posted to the purchase ledger before the year
end or a purchase accrual (equal to the invoice value) has been included in the
accounts at the year end;
if there are book inventory records, I will check that the goods have been included
in the book inventory records before the year end.
There will be a purchases cut-off error where either:
the purchase invoice has not been posted to the purchase ledger before the year end
and there is no purchase accrual; or
the purchase invoice has been posted to the purchase ledger before the year end and
there is a purchase accrual at the year end.
For goods received after the year end, I will select a sample of goods received notes issued
after the year end, and follow through to the purchase invoice. For these goods I will check
that:
neither the purchase invoice has been posted to the purchase ledger before the year
end nor a purchase accrual been included in the accounts at the year end;
if there are book inventory records, I will check that the items of goods received
have not been included in the book inventory records before the year end (they
should have been included in the book inventory records after the year end).
There will be a purchases cut-off error where either:
the purchase invoice has been posted to the purchase ledger before the year end, or
there is a purchase accrual at the year end (and the purchase invoice has been posted
to the purchase ledger after the year end).
(c) Sundry payables and accruals
I will assess the level of accruals, and the systems of control. I will perform less
work on small accruals than material ones. If the companys system of determining
accruals is good, I will perform less work than if controls are weak.
I will compare this years accruals with last year. I will investigate cases where
there was an accrual last year, but none this year, and vice versa. Also, I will
investigate any large changes in accruals.
The wages accrual will be checked to the payroll. As 30 September 2008 is a

Friday (say), the wages accrual will be a whole weeks gross wages.
The wages tax accrual will be checked back to the payroll. I will check to the cash
book that the accrual is equal to the payment to the tax authorities after the year end
(ie in October).
1134
The sales tax payable will be checked as being the tax on sales and purchases (from
the sales and purchases day books) for the months since the end of the last tax
period and tax on sundry cash receipts and payments. If the year end is the end of a
tax period, I will check the tax payable at the year end is equal to the payment to the
tax authorities after the year end.
Accrued interest on the bank loan and overdraft will be checked to the letter I have
received from the bank, and it may be confirmed by the sum charged by the bank
after the year end. For other loans, the accrued interest will be checked as being the
product of the amount outstanding, the current interest rate and the time since the
last charge.
Other accruals will be checked to invoices received after the year end (or if no
invoices have been received after the year end, then invoices received before the
year end will be used). Unless there is any special reason, the charge should be
apportioned on a time basis. For instance, if the electricity bill received after the
year end is :$2,400 for three months and there were two months electricity accrued,
the accrual should be $2,400 = $1,600. Similar checks will be made on other
significant accrued expenses (eg gas, telephone, motor expenses, leasing charges
etc).
I will consider whether there are any circumstances which have arisen in the year
which may result in new accruals, and I will check if these accruals have been
included (or that the accrual is zero).
Answer 56 TOLLERTON
(a) Reconciliation of purchase ledger balance to balance on suppliers statement
$ $
Balance per purchase ledger 5,980
Differences:
(i) 31.3 Discount not allowed by supplier 126

(ii) 4.3 Transposition error invoice 6080 180
(iii) 4.4 Invoice 6210 not on purchase ledger 4,735
(iv) 28.4 Invoice 6355 not on purchase ledger 6,298
(v) 30.4 Cash in transit 6,005
(vi) Discount not allowed? 123
_____
17,467
_____
Balance per suppliers statement 23,447
_____
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(b) Audit work on reconciling items
Discounts allowed
As the difference due to the disallowed discount is very small, I may perform very little work
on this item, and record it as an unadjusted error. However, if detailed checks were
considered necessary, they would be as described below.
From the date of the cash received which pays the February invoices, it appears that Carlton
may not have received the cheque until after 31 March, so it would not be entitled to the cash
discount of 2%. The date the cheque for $6,163 was received by Carlton can be found by
looking at Tollertons bank statement and checking the date it was cleared by the bank. If this
is about 10 April, it indicates that Tollerton delayed sending the cheque to Carlton. If it is
earlier than 10 April, Carlton may have been slow at posting cheques to its sales ledger: I will
look at Tollertons bank statement, and see if cheques issued on 31 March were slow at being
cleared by the bank. If the delay is a week or more, this indicates that Tollerton delays
sending cheques to most suppliers. If most of these cheques are cleared within a week, it
indicates that Carlton is slow at paying customers cheques into the bank.
In addition to these checks, I will ask Tollertons purchase ledger controller about this item,
and inspect correspondence with Carlton. If Tollerton usually pays this disallowed discount
to Carlton, this disallowed discount should be added to the purchase ledger balance. If
Carlton eventually allows the discount, there is no need to add the discount to the balance.
Transposition error
The apparent transposition error on invoice 6080 would be checked by inspecting the invoice.
If the invoice shows $3,752, then an additional creditor of $180 should be added at the year
end to correct this error. No adjustment will be necessary if Tollertons figure is correct.
Omitted invoices
It appears that invoice 6210 for $4,735 has not been included on Tollertons
purchase ledger. As this invoice is dated some time before the year end, the first
question to ask is whether the goods have been received. I will check whether the
goods have been received by looking for the appropriate goods received note (I may
have to ask Carlton for details of this item, if no invoice can be found at Tollerton).
If the goods have been received, I will check if there is a purchase invoice. If there
is a purchase invoice, I will ask the purchases department why the invoice has not
been posted to the purchase ledger. This will probably be because of a dispute,
normally either an incorrect price, the wrong quantity or some faults with the goods.
If the goods relating to this invoice are in inventory (or have been sold) a purchase
accrual should be made for this item. If an excessive price has been charged for the
items, a lower price can be used, provided the same price is used to value the
inventory. If there is a short delivery, the purchase accrual would be for the actual
goods received, rather than for those on the invoice.
I will inspect correspondence on this item with Carlton to assess what will be finally
agreed. If there is no evidence of the goods being received by Tollerton, I will ask
Carlton for details confirming that Tollerton has received the goods (this may be via
Tollertons purchasing department). If there is no evidence that Tollerton has
received the goods, then no purchase accrual for this invoice is necessary.
1136
For invoice 6355, the question is whether Tollerton received the goods before the
year end. I will check if Tollerton received the goods before the year end by
looking at the date on the goods received note. If the date is before the year end,
then Tollerton should include a purchase accrual at the year end for this invoice. If
Tollerton received the goods after the year end, no purchase accrual is required. A
further check that the goods were received is to look at the quantities of the items in
inventory at the year end. If the quantities in inventory at the year end are about the
same as, or more than, those on the invoice, there is strong evidence that the goods
were received before the year end.
Cash in transit
The cheque on 30 April appears to be cash in transit. I will check the date the
cheque is cleared by the bank after the year end. If this is within a week, and most
other cheques are cleared within a week, then this is validly cash in transit. If most
cheques issued immediately before the year end take more than a week to clear, it
indicates they were sent to suppliers after the year end, in which case they should be
deducted from payments before the year end and added to payables (as these were
payments made after the year end).
If, as appears likely, the cheque for $6,005 is not received by Carlton until some
time after the year end, then the discount of $123 will be disallowed by Carlton. If
this discount is disallowed, it should be added to payables at the year end. Checks
on this item are similar to those for item (i) above.
(c) Accounts payable
(i) Basis of selecting suppliers statements
The suppliers statements I will select for checking to the purchase ledger balances
will concentrate on:
accounts with large balances; and
accounts who are large suppliers to the business (ie those who have a large
volume of transactions with Tollerton).
A sample of smaller value accounts payable will be selected, to check that the
purchase ledger is accurate for processing lower value payables and purchase
invoices.
A statistical basis could be used for randomly selecting accounts, such as monetary
unit sampling, but it is unusual for auditors to use this method. A weakness of using
monetary unit sampling is that it would have a low chance of selecting accounts
with a small balance on the purchase ledger, but where the actual balance owing is
large (like the one illustrated in part (a) of the question). The second basis of
selecting accounts (ie selecting large suppliers to the business) would have a greater
chance of selecting such payables.
1137
(ii) No suppliers statement
If there is no suppliers statement for a large balance on the purchase ledger, I will
ask the purchase accounting department if such a statement exists. If no statement
exists at 30 April, I will ask if there is a statement at 31 May.
If there is a statement at 31 May, I will use it to check the balance on the purchase
ledger at 30 April.
If there is no statement on the clients premises, I will contact the supplier (with the
clients permission) and ask them either to send me a copy of the statement, or
confirm the balance on the clients purchase ledger.
If it is not possible to contact the client, I will consider whether the clients system
is reliable at processing purchase invoices. I will look at the balance on the
purchase ledger and consider whether it is reasonable the value of Aprils
purchase invoices should be similar to Marchs. Also I will look at correspondence
with the supplier, and check if there are any invoices on hold which have not been
posted to the purchase ledger. I will see if any goods were received immediately
before the year end, and check that they have either been posted to the purchase
ledger or included as a purchase accrual. Based on these investigations, I will
decide whether the purchase ledger balance is correct.
Answer 57 TOUREX AND PUDCO
(a) Managing conflicts of interest
ACCAs Rules of Professional Conduct state that auditors should avoid conflicts of
interest (both conflicts between the firm and clients, and conflicts between clients)
wherever possible. In some cases, such as these, they are unavoidable.
Full disclosure is important both companies should be fully aware that the firm is
acting for the other party.
One or both companies may object to the firm acting for the other company and the
auditor may be forced to make a decision as to which company to resign from.
However, this is not an attractive course of action because the audits may already
have commenced and it may be difficult for one of the companies to find a new
auditor, quickly.
The auditor should probably not, therefore, resign unless forced to do so this
might be prejudicial to the interests of one of the clients.
It is important in such cases that different teams of staff, and different engagement
partners work on the respective audits.
Internal procedures within the firm should be set up to prevent confidential

information from one client being transferred to the other and the interests of one
firm damaging the interests of the other. Such procedures are sometimes known as
Chinese Walls.
If two completely separate offices could work on the two engagements, so much the
better.
1138
(b) Main requirements of IAS 37
IAS 37 Application
IAS 37 states that a provision is a liability of If the firm can obtain sufficient appropriate
uncertain timing or amount. It should only be audit evidence to show that Tourex and/or
recognised when there is a present obligation Pudco are likely to have to make a payment,
(legal or constructive) arising from past and that the amount can be reliably
events and it is probable that a transfer of estimated, a constructive obligation seems to
economic benefits will be required to settle exist and provision should be made.
the obligation and a reliable estimate of the
amount can be made.
IAS 37 states that a contingent liability is If Tourex and/or Pudco are uncertain as to
either a possible obligation arising from past whether a payment will have to be made, or
events whose existence will be confirmed by if they are certain but the amount cannot be
uncertain future events outside the control of estimated, a contingent liability should be
the entity or, a present obligation arising from disclosed in the accounts.
past events that is not recognised because a
transfer of economic benefits is not probable,
or because the amount of the obligation
cannot be measured with sufficient certainty.
IAS 37 states that a contingent asset is a This might apply to Tourex in its claim
possible asset arising from past events whose against the food company. It seems unlikely
existence will be confirmed by uncertain that there is sufficient certainty relating to the
future events outside the control of the entity. claim and therefore no disclosure should be
Contingent assets should only be disclosed made.
where an inflow of economic benefits is
probable. If they are virtually certain, a
contingency does not exist at all and the
income may be accrued.
It also states that expected re-imbursements If either Tourex or Pudco hold insurance
(such as those arising from insurance against such events, and it is probable that
contracts) should be recognised only where the insurance claim will be met, a contingent
they are virtually certain and treated as asset may need to be disclosed. If there is any
separate assets. The net expense may be uncertainty, there should be no disclosure. If
recognised in the statement of comprehensive it is virtually certain that the claim will be
income. met, a separate asset should be recognised.
A brief description of the nature of each class

of contingent liability should be made unless
the possibility of the transfer of benefits is
remote. Where practical, an estimate of the
financial effect, an indication of the relevant
uncertainties, and the possibility of any
reimbursement should be disclosed. Similar
provisions apply to contingent assets.
1139
(c) Sufficient audit evidence and audit reports
The main problem for the auditors will be gaining sufficient evidence to determine
whether any amounts should be provided for and/or disclosed in the financial
statements of the two companies.
The lawyers refuse to provide anything other than informal evidence and this will
almost certainly not be sufficient to form an audit opinion.
Unless audit evidence can be obtained elsewhere a qualified opinion, except for,
on the basis of a limitation in the scope of the audit may be needed for both
companies as the amounts involved are material.
However, it may be possible to take the view that there is a significant uncertainty,
the resolution of which is dependent on future events that are outside the direct
control of the entity, and that an emphasis of matter paragraph is therefore
appropriate, rather than a qualification to the auditors opinion.
It may be possible for the auditors to suggest to the companies that it would be very
helpful for the lawyers to provide some indication as to their view of the likely
outcome and the amounts involved, in order to avoid a qualified opinion.
The auditors should also take note of the progress of any legal proceedings and any
proceedings that may be instigated by the public health authorities as such
authorities might impose significant fines, and they might even close the businesses
down, which has implications for the going concern status of both.
Answer 58 BOULDER
(a) Six financial statement assertions
Existence: an asset, liability or equity interest exists;
Cut off: transactions and events have been recorded in the correct accounting
period;
Occurrence: a transaction or event that has been recorded took place and pertains to
the entity during the period;
Accuracy and valuation: financial and other information is disclosed fairly and at
appropriate amounts;
Rights and obligations: the entity holds or controls the rights to assets, and liabilities
or obligations of the entity; and
Classification: transactions and events have been recorded in the proper accounts.
1140
(b) Substantive audit procedures
The main concerns with statement of comprehensive income and statement of financial
position entries for payroll relate to the completeness and accuracy of transactions
(existence and rights and obligations), with proper cut-off (occurrence and measurement)
and disclosure.
In relation to both statement of financial position and statement of comprehensive income

entries, I would ensure that appropriate disclosures had been made in the financial statements
in accordance with accounting standards and the statutory framework. The disclosure of
amounts paid to directors is often particularly important.
(i) Payroll balances in statement of financial position, Boulder
(1) Balances that are likely to appear in the statement of financial position of Boulder
are dealt with in items 57 below. In all cases, I would ensure that the amounts
appearing in the financial statements can be traced through to supporting schedules
and ensure that the schedules are arithmetically accurate.
(2) In all cases, I would check the amounts payable to payments made after the period-
end, to documentation supporting and authorising the bank transfer, and to the bank
statement.
(3) In all cases, the extent of testing noted below will depend on the results of tests of
controls over payroll.
(4) In all cases, I would perform analytical procedures on the amounts payable at the
period end by reference to the number of employees, the amounts payable at the end
of each week, month, quarter or year (as appropriate) during the period (and in prior
periods) and with reference to profits, production or sales levels, and/or tax and
social insurance rates, as appropriate.
(5) Unpaid amounts due to the agency

I would consider the need to obtain confirmation from the agency of the
amount payable. If documentation from the agency is available at Boulder
agreeing the amount payable, this might suffice.
I would check the calculation of the amounts payable to supporting

documentation authorised by supervisors.
I would ensure that the amounts payable (particularly the rates payable)
agreed with correspondence with the agency and I would check such
correspondence for evidence of any disputes.
(6) Unpaid wages and salaries due to permanent factory staff, administrative and sales
staff and directors, and unpaid bonuses due to sales staff and directors
I would check the calculation of the amounts payable to appropriately
authorised clock cards or contracts, as appropriate.
(7) Unpaid amounts due to tax authorities for tax and social insurance
I would review correspondence with the tax authorities for evidence of
any disputes or underpayment and pay particular attention to any delay in
the payment of these amounts.
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(ii) Payroll transactions in the statement of comprehensive income, Boulder
(1) As with statement of financial position entries, I would ensure that the amounts
appearing in the statement of comprehensive income can be traced through to
supporting schedules and ensure that the schedules are arithmetically accurate.
(2) In all cases, I would select a sample of entries in the statement of comprehensive
income and trace them through the ledgers and daybooks to source documentation
such as clock cards for permanent factory staff, documentation showing the
amounts produced or processed (agency staff) or contracts (administrative and sales
staff and directors).
(3) I would then trace a sample of source documentation (as noted above) in the
opposite direction, through the daybooks and ledgers to the schedules supporting the
financial statements and to the statement of comprehensive income.
(4) I would perform analytical procedures on the amounts appearing in the ledgers for
each period, for each category of employee with reference to production and sales
levels as appropriate, the number of employees, and by comparison with prior
periods, for example.
Answer 59 NEWTON ELECTONICS
(a) Sales income
In checking whether all sales income due to the company has been included in the financial
statements, I will consider the sources of income (ie in cash, by cheque or charge card). The
risk of cheque and charge card receipts being misappropriated is low. The customer would
make the cheque out to Newton Electronics and, in many countries, it is almost impossible to
negotiate a cheque to another party. Similarly, for most receipts from charge cards a machine
connected to the banks computer is used, which will only accept payments by customers
which are directed to the companys bank account. For manual charge card receipts, the
machine has a stamp which prints the companys mine on the charge card voucher, and the
bank would not make a payment into another bank account.
Thus, the greatest risk is that cash takings are misappropriated by staff or the directors. To
check that all sales are recorded on the till, I will:
note the system for recording and banking cash from the till.
observe the procedures over recording sales on the till. Each item purchased should
be recorded on the till, payment should be received from the customer and the cash,
cheque or charge card receipt should be placed in the till. Ideally, the till should
record the type of payment, so this can be matched with the takings at the end of the
day. There should be no evidence that sales are being made and not recorded on the
till
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at the end of the day, the takings should be counted and banked. As explained
above, if the takings are divided into cash, cheques and charge card receipts, the
amount of each of these should be the same as that banked. Normally, the cash and
cheques will be banked and the charge card receipts will appear automatically on
the companys bank statement. There should be a reconciliation of charge card
receipts per the bank statement to the amount recorded on the till. I will test check
that the amount banked agrees with the total on the till roll. Small differences are
permissible, but larger ones should be investigated. There should be evidence of the
company investigating larger differences and taking appropriate action. Cash from
the till should be banked .promptly and intact. If there is evidence of a delay in
banking takings; there could be a teeming and lading fraud (or lapping fraud).
There is an increased risk of fraud if part of the takings are used to pay other
expenses (including the employees wages).
perform a surprise count of the cash in the tills. The amount counted will be
checked as agreeing with the sub-total produced by the till (after allowing for cash
floats). This type of test can detect unrecorded cash sales which are
misappropriated by the shop assistant at the end of the day (ie. the amount to be
misappropriated will be the difference between the cash in the till and that shown on
the till roll).
Observation by the auditor of the companys procedures is a relatively weak way of detecting
whether cash sales are being misappropriated, as the staff are likely to be honest while the
auditor is watching: However, the use of a video camera and recorder which observes the till
can both deter and detect misappropriation of sales cash. I will be more confident of
completeness of sales income if such a video camera is being used.
Other techniques which can be used to verify completeness of sales income include:
comparing the mix of cheque, charge card and cash income. If on occasions cash
income is unusually small, this may indicate when it is being misappropriated;
looking at total sales each day. There is likely to be a pattern of sales, probably
with more sales taking place on Saturday (and Sunday if they are open). I will
investigate when sales appear to be unusually low. Sales should be high before
Christmas (say) and during sales (ie when products are sold at a discount);
checking the gross profit margin, as described below.
Checking whether the gross profit margin is reasonable is an effective way of determining
whether all sales have been included in the financial statements. It is probable that purchases
of products for sale as recorded in the financial statements will be correct, as the company
will record them in the accounting records (as the payments will probably be on credit and the
payment will be made from the companys bank account) and it is unlikely that the company
will understate this figure (as otherwise the Managing Director or member of staff would have
to pay for the items purchased himself/herself). If we have an accurate estimate of the gross
profit margin and purchases are accurate, then, allowing for changes in inventory, the sales
can be estimated. These estimated sales can be compared with sales in the financial
statements and the auditor can consider whether the difference is reasonable and thus whether
sales in the financial statements are correct.
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The gross profit margin can be estimated by:
comparing this years gross profit margin in the financial statements with last year.
This is a weak way of checking the gross profit margin, as the proportion of sales
misappropriated each year may be similar, thus giving a similar reduction in overall
gross profit margin.
determining the gross profit margin on actual sales and comparing this with the
gross profit margin in the financial statements. As auditor, I will obtain the
purchase price from purchase invoices and the selling price from the price of the
product in the store. Allowance will be made, where appropriate, for the effect of
recoverable taxes on sales and purchases. A weighted gross profit margin would be
calculated using the mix of sales of types of product and their gross profit margins.
The mix of sales would be found by checking purchasing records (if the categories
of products are separately analysed when processing purchase invoices) or asking
the companys staff (when I will consider whether their representations are reliable).
Using this method, it is probable that the gross profit margin I calculate will be higher than
the figure in the financial statements. I will consider whether the difference is reasonable.
The gross profit margin would be depressed by selling products at a lower than normal price
(eg in a sale) or where products are returned by customers and later. sold at a lower price or
scrapped. Wastage of inventory (or shrinkage), due to it becoming damaged or stolen by
customers will further reduce the gross profit margin.
As a further check on completeness of income from sales of high value items, I will select a
sample of products (eg Sony 60cm television). For each item, I will note the quantity of
opening inventory and closing inventory. From purchase invoices I will find the quantity
purchased in the year, and the number sold will be found from sales invoices. From this
information it should be possible to determine the number and value of televisions which
disappeared in the year. These would be the televisions for which there is no record of the
sale. The sales invoices should be checked to the till rolls (and bank records if they are
purchased by cheque or charge card) to verify that cash was received and banked for these
sales.
Based on this work, I will decide whether the gross profit margin in the financial statements is
reasonable and sales income is not materially misstated.
(b) Reliability of management representation letter
Normally, the management representation letter is drafted by auditors, but it is written on the
clients headed notepaper and signed by the directors. Alternatively, the letter may be written
by the directors; but contain matters requested by the auditors. As audit evidence, it is written
evidence (which is better than verbal evidence) but it is evidence from within the company.
This evidence is from the directors, who are within the company and thus it is not as
independent a source of evidence as most other evidence obtained by the auditor (eg third
party evidence and evidence obtained directly by the auditor). In some respects evidence
from directors may be less reliable than evidence from the companys employees, as there
may be more pressures and motivation for the directors to mislead the auditor (eg because
they were misappropriating some of the takings). In another respect, statements from the
directors may be more reliable than those from employees, as they may have a better
understanding of the situation and, in their position as directors, they may better realise the
importance of the statements they make to the auditor. Company legislation may make it an
offence for a company director to make a misleading, false or deceptive statement to the
auditor. This should make directors careful of what they say to auditors, particularly when it
is in writing.
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In some relatively immaterial areas, the auditor may accept the directors statements without
seeking further evidence. However, in most situations the auditor should attempt to find
alternative evidence to support (or refute) the directors representations. Thus, in determining
whether all sales income has been recorded in the financial statements; the auditor should
obtain other evidence and he would probably be negligent if he relied entirely on the
directors representations. In addition, the auditor must consider whether the directors
representations are consistent with the other information he has obtained. If this evidence is
consistent, then the directors representations will reinforce the evidence obtained by the
auditor. However, if the other evidence obtained by the auditor is not consistent with the
directors representations; the auditor should be extremely careful before accepting what the
directors say. He should seek further evidence to either refute or confirm the directors
statements. If there is a material difference between the other evidence and the directors
representations, the auditor will probably have to qualify the auditors report, or give an
unqualified report with an explanatory paragraph which explains the inherent uncertainty.
(c) Refusal to sign
Where the directors refuse to sign the management representation letter, I will ask them why
they are refusing to do so. I will explain that:
it is a normal procedure for auditors to draft the management representation letter

and ask the directors to sign it
my audit opinion will be based mainly on audit work which does not involve
representations from directors. However, directors representations are helpful in
providing further evidence that the financial statements are free from material error
company legislation will probably require the directors to sign the financial
statements, and the directors have responsibility for preparing financial statements.
This provides evidence that the directors believe the financial statements are free
from material error. Thus; this is little different from the directors signing the
management representation letter
If they are still unwilling to sign the management representation letter, I will ask them .which
paragraphs they are unhappy about. We will discuss the wording of these paragraphs and see
if they will sign a letter with alternative wording. However, I will have to ensure the
alternative wording provides what I require (ie it would probably be unacceptable to remove
the paragraph where the directors confirm completeness of income).
If the directors continue to refuse to sign the management representation letter, it makes me
suspicious they are hiding something. Thus, I will have to carry out additional audit
procedures in the areas where the matters have been excluded from the management
representation letter. There is a significant risk that the directors refusing to sign the
management representation letter will lead me to having either to qualify my auditors report
or include an added emphasis paragraph in an unqualified auditors report which explains an
inherent uncertainty (eg I am unable to confirm the completeness of sales income).
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Answer 60 AJIO CHARITY
(a) Risks and implications for audit risk
Inherent and control risks
Charities can be viewed as inherently risky because they are often managed by non-
professionals and are susceptible to fraud, although many charities and the
volunteers that run them are people of the highest integrity who take a great deal of
care over their work. The assessment of this aspect of inherent risk depends on each
individual charity and the areas in which it operates.
Charities are also at risk of being in violation of their constitutions which is

important where funds are raised from public or private donors who may well object
strongly if funds are not applied in the manner expected. Other charities and
regulatory bodies supervising charities may also object. Again, the auditors will
assess the level of risk. The involvement of a recently retired Chartered Certified
Accountant in the preparation of accounts in the past may lower the auditors
assessed inherent risk to an extent.
Most small charities have a high level of control risk because formal internal
controls are expensive and are not often in place. This means that donations are
susceptible to misappropriation. Charities rely on the trustworthiness of volunteers.
The auditors will assess the level of risk.
Detection risk
Detection risk comprises sampling risk and non-sampling risk. It is possible in this
case that all transactions will be tested and therefore sampling risk (the risk that
samples are unrepresentative of the populations from which they are drawn) is not
present.
Non-sampling risk is the risk that auditors will draw incorrect conclusions because,
for example, mistakes are made, or errors of judgement are made in interpreting
results, or because the auditors are unfamiliar with the client, as is the case here.
Audit risk
Audit risk is the product of inherent risk, control risk and detection risk and is the
risk that the auditors will issue an inappropriate audit opinion. This risk can be
managed by decreasing detection risk by altering the nature, timing and extent of
audit procedures applied. Where inherent risk is high and controls are weak (as may
be the case here) more audit work will be performed in appropriate areas in order to
reduce audit risk to an acceptable level.
(b) Audit tests fund raising events
Attend fund raising events and observe the procedures employed in collecting,
counting, banking and recording the cash. This will help provide audit evidence that
funds have not been misappropriated and that all income from such events has been
recorded. Sealed boxes or tins that are opened in the presence of two volunteers are
often used for these purposes.
Perform cash counts at the events to provide evidence that cash has been counted
correctly and that there is no collusion between volunteers to misappropriate funds.
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Examine bank paying in slips, bank statements and bank reconciliations and ensure
that these agree with records made at events. This also provides evidence as to the
completeness of income.
Examine the records of expenditure for fund raising events (hire of equipment,
entertainers, purchase of refreshments. etc.) and ensure that these have been
properly authorised (where appropriate) and that receipts have been obtained for all
expenditure. This provides evidence as to the completeness and accuracy of
expenditure.
Review the income and expenditure of fund raising events against any budgets that
have been prepared and investigate any significant discrepancies.
Ensure that all necessary licences (such as public entertainment licences) have been
obtained by the trustees for such events in order to ensure that no action is likely to
be taken against the charity or volunteers.
Obtain representations from the trustees to the effect that there are no outstanding
unrecorded liabilities for such events again for completeness of expenditure and
liabilities.
Answer 61 ISAs
(a) Common ownership and management
The existence of an owner-manager who is actively involved in the day-to-day

running of the business is a common feature of smaller entities.
This characteristic can be seen as increasing audit risk because such an owner-
manager is easily able to override any internal controls that have been set up
(although the management override of internal controls is not restricted to smaller
entities and has been a feature of many large corporate scandals).
On the other hand, this characteristic can also be seen as decreasing audit risk
because the presence of the owner-manager on a day-to-day basis can be seen as an
effective substitute for formal internal controls.
Risk assessment will depend on the auditors knowledge of the integrity and
competencies of the owner-manager (or any single manager to whom the owner has
delegated his management duties).
The owner-manager may not understand why an audit is necessary and may fail to
co-operate with the auditor. The owner-manager may also be buying a suite of
services from the auditor, including tax, accounting and systems advice which may
give rise to problems of independence for the auditor, particularly if the auditor is a
sole practitioner (see below).
(b) A control framework that is different to the control framework for larger entities
International Standards on Auditing need to accommodate the needs of auditors of

larger and smaller entities and always make reference to a full range of internal
formal controls. Many smaller entities lack formal internal controls; a lack of staff
amongst whom to segregate duties for example and a lack of authorisation controls.
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As noted above, the presence of the owner-manager can compensate for this lack of
control in the auditors risk assessment. Auditors should not assume that because
formal internal controls do not exist, there is no internal control framework to be
assessed.
High-level general or environmental controls, such as those relating to entity

requirements for integrity in those in whom trust is placed, and controls involving
the overall review of day to day accounting records (such as invoices, the bank
statement and management accounts) may or may not be formally documented, but
such controls can be evidenced in other ways and can therefore be tested.
It is always efficient for auditors to rely on internal controls wherever possible.

However, where no such controls exist, auditors may decide that a wholly
substantive approach is more appropriate.
(c) The use of standardised computer packages
Well-established standardised computer packages are generally more reliable and

auditor-friendly than they used to be. Computer Assisted Audit Techniques
(CAATS) have been developed for use with some such packages, for example, and
many small firms of auditors advise their clients on the selection of such packages,
although this can create independence problems (see below).
Such packages may not be easily adaptable to the particular needs of very small
entities and some such packages still fail to provide an adequate audit trail.
The common use of well-established computer packages enables auditors to become

familiar with their advantages and disadvantages, which makes planning audits
more efficient and enables auditors to provide useful recommendations to clients
where problems are encountered.
The proper use of computer packages by adequately trained staff means that, to an
extent, there is less scope for a certain type of human error; this may have an effect
on the auditors risk assessment. However, systematic errors resulting from
inadequate programming or from the inappropriate use of such packages can give
rise to significant risks such as large volumes of data that lack integrity.
Teething problems are always encountered where such packages are introduced
which also has to be factored into the risk assessment and time budget for the audit.
(d) Reliance on the auditor for accounting expertise
The packages referred to above mean that staff at many smaller entities are able to
produce a trial balance, which might not have been possible with a manual system.
However, many smaller entities still rely on auditors for the preparation of the final
statutory financial statements. ACCAs Rules of Professional Conduct permit this.
The Rules do not permit the auditor to prepare the basic accounting records, to
initiate transactions or to prepare journal entries, for example. This is because
auditors must not perform the function of management, otherwise they will be
reporting on their own work.
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In practice, the dividing line between what constitutes advice to the client, and
what constitutes doing the clients job for the client, can be difficult to draw, and
clients often want their auditors to do their jobs for them. For example, a client
might wish the auditor to help sort out a difficult reconciliation. It is therefore
important for auditors to explain clearly to the directors of their clients that directors
have responsibilities for the accounting records. Auditors should also ensure that
properly drafted engagement letters are in place.
It is important that where auditors are involved in the preparation of the financial
statements in any way, that other audit staff review their work.
Where auditors are providing a suite of services (accounting expertise, tax advice
and advice on computer packages, for example), they may wish to consider whether
they can be seen to be independent (as required by the Rules) and whether
appropriate safeguards can be put into place to maintain the auditors independence
and objectivity.
(e)
A lack of sufficient appropriate audit evidence to support financial statement assertions

relating to income for cash transactions
Where auditors are unable to obtain sufficient appropriate audit evidence on any
material area in the financial statements, they must qualify their audit report on the
grounds of a limitation in the scope of the audit (except for).
If the effect of the lack of evidence is pervasive and affects the view given by the
financial statements as a whole, the auditor may need to disclaim an opinion (the
auditor cannot form a view as to whether the financial statements give a true and
fair view).
Qualifications and disclaimers of opinion may be regarded as problematic if they

are attached to financial statements that are presented to banks or other providers of
finance. If they are attached to financial statements supporting tax computations this
may give rise to the possibility of a tax investigation. This may harm the
relationship between auditor and client and the client may seek to persuade the
auditor to issue an unqualified opinion where it is not appropriate.
Auditors should consider carefully whether they wish to accept audit engagements
where they know at the outset that the client is unable or unwilling to provide them
with sufficient appropriate audit evidence (auditors should not be associated with
fraud).
Owner-managers may seek to persuade auditors, either verbally, or by written

management representations, that cash transactions are complete, despite the lack of
written evidence. Management representations are no substitute for audit evidence
that should be present.
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Answer 62 DYLAN
(a) Subsequent events
In auditing terms (ie ISA 560) subsequent events means all events occurring after the period
end ie both events occurring between the period end and the date of the auditors report and
facts discovered after the date of the auditors report.
In accounting terms, events after the reporting period (IAS 10) are restricted to those events,
both favourable and unfavourable, that occur between the statement of financial position date
(ie period end) and the date on which the financial statements are authorised for issue (which
is usually the date on which the auditors report is signed).
IAS 10 distinguishes between two types of events:
those which provide further evidence of conditions existing at the year end
(adjusting events); and
those that indicate conditions that arose subsequent to the end of the reporting
period (non-adjusting events).
(b) (i) Information (ii) Audit procedures
Tutorial note: The Q called for just FOUR areas of the financial statements to be identified. The list
of FIVE which follows is not exhaustive.
Inventory
The ultimate sale proceeds (if any) of year- For major lines of inventory, compare after-
end inventory. This is relevant to date sales invoice prices with year-end cost.
establishing net realisable value (NRV).
Inspect condition of inventory items where
Inventory should be stated at the lower of
no sales (eg as identified by an exception
cost and (NRV). Also, the receipt of after
report) have occurred since the year end.
date proceeds provides evidence of the good
condition (or otherwise) of inventory (ie an If material, obtain management
adjusting event). representation to confirm the directors
considered view (eg that NRV of slow-
moving inventory against which no
provision has been made will exceed cost).
Trade receivables
Cash received after the year end. The For major customers, review after-date cash
collectability of accounts receivable is receipts.
relevant to determining the adequacy of any
Review direct confirmation
allowance (provision) for bad and
(circularisation) suppliers and other
doubtful debts. Receivable should be stated
correspondence with customers for evidence
at their recoverable amount in the statement
of disputes or notification of
of financial position. The renegotiation of
receivership/liquidation.
amounts owed by customers or notification
of their insolvency are adjusting Review the latest available aged debt
subsequent events. analysis to identify post year-end
deterioration in the recovery of trade
receivable balances.
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Trade payables
Cut-off information concerning year-end Examine suppliers statement reconciliations
trade payables and accrued expenses. The and confirm that reconciling items have
accuracy of inventory and payments cut-off been properly accounted for (eg year-end
is relevant to confirming that liabilities are goods received not invoiced should be
not materially understated in the financial accrued).
statements.
Scrutinise significant after-date cash book
payments and confirm the year-end account
payable or that no liability existed.
Review the 30 April bank statement
reconciliation for unpresented cheques
representing payments to suppliers withheld
at the year end (ie bank/creditor cut-off
error resulting in understatement of both).
Contingent liabilities
The expected outcome (or further evidence Review all minutes of meetings and
of) any contingent liabilities (eg legal correspondence with solicitors (including
claims) as at the date on which the financial bills rendered) and insurers to date to
statements are approved is relevant to the ascertain latest position.
appropriate accounting treatment (ie
Request written confirmation from Dylans
disclosure or provision).
solicitors.
Obtain written management representation
to the effect that (say) similar claims are not
expected to be received.
Property, plant and equipment

Impairments in the value of items of Physically inspect significant assets for
property, plant and equipment. Values evidence of deterioration.
impaired during the year under review may
Where any class of asset is measured at a
not be detected until after the year end.
revalued amount (per IAS 16) review any
Impairment losses must be recognised when
appraisals undertaken/reports issued since
the recoverable amount of an item is less
the end of the reporting period.
that its carrying amount (ie book value).
Obtain written management representation
confirming that there have been no events
since the end of the reporting period which
necessitate revision to the balances included
in the financial statements.
(c) (i) Between 31 August and 17 November
Advise management how to properly account for and adequately disclose such
events in the financial statements.
If not amended or disclosed in the financial statements, qualify the auditors report
except for on the grounds of disagreement (as the matter is material).
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(ii) Between 17 November and 5 December
Discuss the matter with management and take action appropriate to the
circumstances. For example, request that the financial statements as they currently
stand and the auditors report thereon should not be issued.
If the financial statements are amended
Extend subsequent event review procedures to the date of the new auditors report.
Provide a new auditors report dated not earlier than the date the amended financial
statements are approved.
If unamended financial statements are subsequently issued
Take action to prevent reliance on the auditors report (eg the auditor can attend a
meeting of the company).
Consider taking legal advice.
Resign (in extreme circumstance) in those jurisdictions where legal rights can be
exercised to bring the matter to the attention of shareholders.
(iii) After 5 December
Discuss with the directors how they intend to deal with the situation, in particular,
whether they intend to communicate with members.
If, the directors are not dealing correctly with the situation, consider taking legal
advice.
If revised financial statements are to be issued, issue a new report thereon including
an emphasis of matter paragraph (referring to a note discussing the reason for the
revision and earlier auditors report thereon).
Answer 63 REDDY
(a) Subsequent event
The agreement to pay a backdated pay rise is an adjusting event since it clearly relates to a
prior period even though the extent of the pay rise was unknown as at the year end (IAS 10
Events After the Reporting Period). Reddy and Co should confirm the pay rise by sighting
the agreement, check the computation of the amount outstanding as at the end of the reporting
period and assess the materiality of the effect on profit. They should recommend the directors
to provide for the backdated pay for the period from 1 July to 30 September as a liability in
the statement of financial position as at 30 September and to adjust expense accounts in the
statement of comprehensive income as appropriate. If the directors do not do so then it
represents a disagreement. If the amount is material, the auditors report will need to be
modified by way of a qualified (except for) opinion due to disagreement.
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(b) Other information
The Chairmans statement would appear to represent a material inconsistency with the audited
financial statements in accordance with ISA 720 Other Information in Documents Containing
Audited Financial Information. It suggests that operating profit represents the true level of
performance. IAS 1 Presentation of Financial Statements, however, requires items such as
reorganisation costs and profits or losses on disposal of property, plant and equipment to be
included in arriving at a measure of profit from ordinary activities for the period (also IAS 8
Accounting Policies, Changes in Accounting Estimates and Errors). Reddy and Co should
advise the Chairman to amend the information in his statement to avoid the apparent
inconsistency. If the Chairman refuses Reddy and Co should consider taking appropriate
action. One possibility is the inclusion of an emphasis of matter paragraph immediately after
the unqualified opinion paragraph in the auditors report. If the matter were considered to be
more serious Reddy and Co could refuse to issue the auditors report or withdraw from the
engagement subject to receiving appropriate legal advice.
(c) Internal control
Although advising audit clients of weaknesses discovered in internal controls is not the
primary objective of an audit, various jurisdictions have held the auditor to be negligent if
failure to make proper communication of such information results in losses being incurred by
the company. It is generally known that potential losses from unauthorised trading of this
kind can be very large (Barings Bank).
Jane should review more recent dealings to see if any have been entered into speculatively it
is possible that the practice has ceased even though no action has yet been taken. If such
transactions are still being entered into, Jane should discuss with the chief financial officer if
there has been a change in company policy. If so, this should be evidenced in board minutes
and Jane should update the permanent audit file.
Tutorial note: Reference could also be made that if policy has not changed, the letter point
should be redrafted (and to more senior management).
Since the chief financial officer appears not to have taken appropriate action Reddy and Co
must, as a matter of urgency, raise the matter with the Board of Directors or, if the company
has one, the Audit Committee.
(d) Subsequent event
This is a non-adjusting event (IAS 10). On the basis of the preliminary information it would
appear to be of a magnitude to require disclosure. The disclosure should describe the nature
of the event and an estimate of its financial effect (i.e. the cost of cleaning up operations and
of liability to pay compensation) or a statement that such an estimate cannot be made. If the
company is unwilling to disclose the event in the notes to its financial statements then Reddy
and Co are in disagreement with management and must issue a qualified opinion in their
auditors report.
Disclosure may be required in the directors report as well as in a note to the financial
statements.
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Answer 64 CREMORNE
(a) Inventory valuation
The chief financial officers view that the write down should be reflected after the end of the
reporting period is irrelevant. As at the end of the reporting period the material could not be
used in road construction and, as such, its value, at the lower of cost and net realisable value,
was $2 million. The issue of the report failed to change the situation. The value of inventory
and operating profit should, therefore, be reduced by the amount of the write down to net
realisable value, being $5 million. This amount is material being in excess of 10% of
operating profit.
If Cremorne fails to adjust its financial statements, the effect on the auditors report would be
an except for qualified opinion as the matter affects only inventory valuation and is,
therefore, not pervasive. The cause of the qualification is a disagreement with management
and the auditors report would describe the nature of the disagreement and quantify the effect
on the financial statements. The opinion paragraph would then express a qualified opinion
using the phrase In our opinion, except for and then refer to the matters described.
(b) Depreciation
IAS 16 Property, Plant and Equipment requires that useful lives of assets be reviewed
regularly and the depreciation adjusted where there is found to be a change in useful life. The
chief financial officers claim that technological obsolescence need not be taken into
consideration is not consistent with IAS 16. Depreciation for the current financial year should
be adjusted so as to write off the written down value of computer controlled earth movers
over their revised useful life.
Year of Cost Depreciation Written down Remaining Required Depreciation Adjustment

purchase $000 to 1/10/07 value 1/10/07 useful life in depreciation provided required
$000 $000 years charge for 2008 $000
including 2008 based $000
on an overall
2008 life of 5 years
$000
2005 5,000 1,500 3,500 2 1,750 500 1,250

2008 8,000 8,000 5 1,600 800 800
2,050
The depreciation charge should be increased by $2,050,000 which would have the effect of
reducing the written down value of plant and equipment and of profit from operations by that
amount.
If there were no other uncorrected errors I would probably accept the amount as not being
sufficiently material to justify issuing a modified audit opinion if the financial statements
were not adjusted. It is just over 5% of operating profit but depreciation is based on an
estimate of the useful economic lives of the assets. As such it is not a precise amount and, on
a qualitative basis, does not indicate the financial statements are necessarily materially
misstated.
If there were other detected but uncorrected errors in the financial statements then, no matter
how small these other errors might be, it would probably be appropriate to qualify my opinion
on the financial statements along the same lines as in the case of inventory valuation.
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(c) Contingent liability
A threat to claim for damages might be regarded as remote but the actual issue of a claim
must be taken seriously. If successful, the claim would certainly be material being in excess
of the years profit. There certainly appears to be some substance to the claim and the
existence of the lawsuit should be disclosed in the note on contingent liabilities. This note
needs to be reasonably comprehensive as to the basis for the claim, the amounts involved, and
the companys grounds for not making a provision.
If the company does not disclose the existence of the lawsuit a qualified opinion is required as
the amount is significant but not pervasive. The nature of the qualification is a disagreement
with management as to the adequacy of disclosure. The auditors report should describe the
nature of the disagreement including details of the contingency. The opinion paragraph
would then commence with the phrase In our opinion, except for followed by a reference to
the description of the disagreement.
A further concern is that the existence of the lawsuit might constitute a significant
uncertainty. Even if the company properly disclosed the contingent liability, it should be
referred to in the auditors report after the opinion, as an emphasis of matter.
Answer 65 THETA
(a) Scope paragraph (extract)

The evidence available to us was limited because many of the companys accounting records
were destroyed by fire in January 2008. The financial statements therefore include significant
amounts based on estimates. In these circumstances there were no satisfactory audit
procedures that we could adopt to obtain all the information and explanations we consider
necessary.
Opinion paragraph
Limitation on scope Disclaimer of Opinion
Because of the significance of the limitation on the evidence available to us, we do not
express an opinion2 on the financial statements.
(b) Reasons for audit opinion
The fire has resulted in limitations in audit work and evidence necessary to form an
opinion cannot be obtained.
It is a matter of fact that accounting records adequate for audit purposes have not
been kept and all information and explanations necessary for audit purposes have
not been received.
Disclaimer
The effect of the limitation is so material and pervasive that it is not possible to
express an opinion on the financial statements.
2
An except for opinion could be appropriate, ie except for the effects of such adjustments, if any, that might
have been determined to be necessary had we been able to satisfy ourselves as to . . .. The choice of opinion
(ie disclaimer v except for) must be justified in part (b).
1155
For example, significant estimates include net book values of tangible non-current
assets, inventory valuations, recoverable amounts of trade receivables, provisions
for unrecorded liabilities, revenue and cost of sales.
Alternatively Except for
The effect of the limitation is not so material and pervasive as to require a

disclaimer of opinion.
For example, the extent of reconstruction facilitated and analytical procedures

performed is such that uncertainty only remains in respect of unrecorded liabilities
(say).
(c) Forms of modified audit opinion
(i) Emphasis of matter
An emphasis of matter is clearly distinguishable from other modifications (eg

qualified opinions) in that it doe not affect the auditors opinion.
An emphasis of matter paragraph highlights a matter affecting the financial

statements which is discussed in note to the financial statements, for example, going
concern.
The paragraph is included after the opinion paragraph Without qualifying our
opinion (above) we draw attention to Note X.
(ii) Qualified opinion
An except for opinion is expressed when the auditor cannot express an unqualified opinion
but the effect of the matter (disagreement or limitation on scope) is not so material and
pervasive as to require an adverse opinion or disclaimer of opinion.
(iii) Disclaimer of opinion
An auditor is unable to express (ie disclaims) an opinion when the effect of a limitation on
scope is so material and pervasive that the auditor has been unable to obtain sufficient
appropriate audit evidence (which may be reasonably expected to be available).
(iv) Adverse opinion
The effect of a disagreement is so material and pervasive that the auditor concludes that a
qualification is not adequate to disclose the misleading or incomplete nature of the financial
statements.
Distinctions
There are three issues which distinguish the form of modified reports
1 EITHER the matter does not affect the auditors opinion (ie (i)) or it does (ie (ii),
(iii) and (iv))
1156
If the audit opinion is affected, then:
2 EITHER there is sufficient appropriate evidence on a matter for the auditor to

disagree with the amount, treatment or disclosure in the financial statements (as in
(iv));
OR there is insufficient evidence due to scope limitation (in (iii)).
3 EITHER the matter is so material and pervasive (as in (iii) & (iv)) resulting in
Because of the significance of (extreme opinions);
OR not so material and pervasive (as in (ii)) resulting in an except for opinion.
Answer 66 ABC COMPANY
(a) Audit and review engagements
Audit reports are dealt with by ISA 700 The Independent Auditors Report on a Complete
Set of General Purpose Financial Statements and review reports are dealt with by ISRE 2400
Engagements to Review Financial Statements.
(i) Audit engagements: work performed and assurance provided
Audit engagements provide a moderate level of positive assurance to the user. They require
the auditor to:
Obtain a detailed understanding of the entity, its environment and its internal
control sufficient to identify and assess the risks of financial misstatement. .
Obtain detailed audit evidence in respect of the financial statement assertions by

means of tests of internal controls and/or detailed substantive testing, and to
corroborate explanations received.
Perform a review of the going concern status of the company.
(ii) Review engagements: work performed and assurance provided
Review engagements provide a limited level of assurance that may be expressed as negative
assurance. They consist principally of analytical procedures and inquiries made by the
reviewer. The reviewer is not required to understand the accounting and internal control
system, nor is he required to corroborate explanations, perform detailed tests on material
financial statement assertions or to conduct a going concern review.
(iii) Addressee
Audit reports are generally addressed to the shareholders or other owners of

companies, review reports are addressed to directors or other management. This is
because most audit engagements are statutory audit engagements (where the auditor
reports to shareholders on the financial statements prepared by directors).
Statutory audit reports, particularly those of large companies, are often made
available to the general public because they are filed with the financial statements at
a public registry or are otherwise made available to potential investors and other
interested stakeholders.
1157
Review reports are generally not made available to the general public. They are
generally private engagements between directors and reviewers and sometimes a
third party, such as a bank, who may wish to see a report for a specific purpose.
(iv) Responsibility for the financial information
The responsibility for the preparation of financial information in both audit and
review engagements is always that of directors, regardless of who has actually
prepared the information. This is stated in both review and audit reports because it
is easy to assume that the auditor or reviewer has prepared the information and is
responsible for it.
It is particularly important to state this in audit reports because legislation often

makes directors responsible for the statutory financial statements.
(v) The opinion given
The two opinions provided by an audit engagement relate to the true and fair
status of the information or to its fair presentation in all material respects and to
proper preparation in accordance with an identified financial reporting framework,
such as International Accounting Standards.
The opinion given in the review report is not that the financial statements give a
true and fair view (a positive opinion), but that nothing has come to the
reviewers attention to indicate that they do not (a negative opinion).
The different level of assurance provided is commensurate with the different level
of work performed, as indicated above. There is no precise definition of the
meaning of true and fair or fair presentation in all material respects.
(b) Direct and assertion engagements
Direct engagements require professional accountants (eg auditors) to report directly on

financial statements or other information that is the responsibility of a third party, such as
directors. A review engagement (eg to review a set of financial statements to see if they
comply with IFRS) is a typical example of a direct engagement.
Assertion engagements involve professional accountants reporting on assertions made by

directors on financial or other information. For example, directors may make an assertion on
financial internal controls to the effect that they have reviewed them, and have found them to
be working effectively. Auditors then report on the directors assertion, rather than on the
internal controls themselves. Auditors or reviewers will look at the processes that directors
have been through in order to make the assertion and report their findings. An audit of a set
of financial statements can be taken as a typical benchmark for an assertion engagement.
1158
Answer 67 ISA 570 REVISED
(a) Meaning of going concern basis
Assets are recorded on the basis that the company will be able to realise or recover
them at or above recorded amounts in the normal course of business.
Liabilities are recognised and recorded on the basis that they will be discharged in
the normal course of business.
The IASBs Framework defines the going concern concept as meaning that the enterprise will
continue in operational existence for the foreseeable future. This means that the financial
statements are prepared on the assumption that there is no intention or necessity to liquidate
or curtail significantly the scale of operation.
(b) Procedures for obtaining sufficient evidence
Tutorial note: Evidence should be obtained sufficient to confirm or dispel whether or not
material uncertainty exists.
A review of forecast and budget information produced by a company, and the
reliability of the systems in place for producing this information. This would
include a review of the key assumptions underlying the forecasts and budgets, and a
comparison actual results against budgets.
A review of the evidence relating to the adequacy and period of borrowing facilities.
The auditor may need to obtain written information from banks or other third parties
in order to be able to assess the degree of their commitment (and the legality and
enforceability of financial support).
A review of the inherent risk assigned to the audit client. The sensitivity of
forecasts and budgets to variable factors both within the directors control and
outside their control will be scrutinised, including relevant economic factors.
A review of the directors plans for overcoming any problems their company is
having or resolving any matters giving rise to doubts about the appropriateness of
the going concern basis. The auditor should consider the basis on which they have
been prepared, whether they are realistic and whether the plans are likely to resolve
the companys problems.
A consideration of any professional advice obtained by the directors as to the extent of

the companys difficulties and the practicalities of overcoming them. It may be
necessary for the directors to obtain legal advice on:
the consequences of the company continuing to trade while it is known by

the directors not to be a going concern; or
the existence of litigation and claims.
A review of the financial records including the order book, directors minutes and
an analytical review of the financial statements.
Reviewing the terms of loan and overdraft agreements and determining whether
they have been breached (eg late payments, exceeding limits).
1159
The nature and scope of the auditors procedures will depend upon the circumstances of the
client. The extent of the procedures will be determined by the extent of the resources it
requires to continue as a going concern.
(c) Factors which might cast doubt on the going concern status of a company
Tutorial note: The Q only called for 6 factors. The following is not an exhastive list of the
examples of the financial, operating and other events or conditions that may cast doubt on the
going concern assumption.
Financial
An excess of liabilities over assets and/or adverse key financial ratios.
Default on terms of loan agreements or inability to pay other creditors on due dates.
Significant impairment in the value of assets used to generate cash flows or

substantial operating losses.
Significant liquidity or cash flow problems indicated by negative operating cash

flows in historical or prospective financial statements.
Denial of normal terms of credit by suppliers or other indications of withdrawal of

financial support by suppliers (eg change from credit terms to cash-on-delivery).
Major debt repayment falling due where refinancing is necessary to the companys
continued existence and there are no realistic prospects of renewal or repayment.
Arrears or discontinuance of dividends.
Inability to raise finance for essential investment, new product development, etc.
Operational
Internal matters such as:
loss of key management without replacement;

labour difficulties; or
excessive dependence upon a few product lines where the market is
depressed.
External matters such as:
loss of key suppliers, customers or major markets;

shortages of essential supplier; or
technical developments which render a key product obsolete.
Other
Major litigation in which an adverse judgement would result in claims that are
unlikely to be satisfied, imperilling the companys continued existence.
Non-compliance with statute, environmental legislation, etc.
Adverse effects of changes in legislation or government policy.
1160
(d) Auditors responsibilities
Before the issue of ISA 570 Going Concern, professional requirements concerning going
concern had a passive air about them. Where the auditor was satisfied that the financial
statements had been prepared on a going concern basis, no mention of any matters relating to
the going concern status would normally be required in the auditors report.
The current guidance in ISA 570 goes somewhat further. There is now a duty on the part of
the auditor to plan and perform procedures specifically designed to identify material matters
which might cast doubt upon the going concern status of the company.
It would be possible to extend the auditors responsibilities still further. For example ISA 570
does not stipulate a strict time period beyond the end of the reporting period over which the
auditor should satisfy himself that the company will remain in operation. It would be possible
for a revised ISA 570 to insist that the auditors report specifically includes a statement that
the auditors opinion is that the company will remain in operational existence for at least the
following twelve months, unless stated otherwise. This requirement would highlight the issue
of going concern more than is currently the case.
Answer 68 CORSCO
(a) External auditor responsibilities going concern
ISA 570 Going Concern deals with this issue.
Auditors are required to consider the going concern status of companies and any
disclosures regarding going concern in forming their audit opinion. Companies that
are listed on stock exchanges may be required to make additional disclosures in
relation to going concern issues.
Auditors are required to assess the adequacy of the means (the processes) by which
directors have satisfied themselves that the going concern basis is appropriate and
that adequate disclosures have been made. Auditors conduct an initial analysis at the
planning stage of the audit as well as assessments at later stages.
Auditors should make enquiries of the directors and examine appropriate

documentation supporting the companys going concern status such as budgets and
cash flow forecasts.
Auditors consider whether the period to which directors have paid particular
attention is adequate. This should normally be at least 12 months from the end of
the reporting period. Auditors also enquire of management as to their knowledge of
events or conditions beyond this period that may cast significant doubt on the
entitys ability to continue as a going concern.
Auditors need to consider the appropriateness of assumptions which directors have

made, the sensitivity of assumptions to external and internal changes, any
obligations, guarantees or undertakings arranged with other entities, the existence
and adequacy of borrowing facilities and the directors plans to deal with any going
concern problems.
Auditors are required to document the extent of any concerns, taking account of
matters that have come to their attention during the course of the audit and in
particular, financial, operational, or other indicators of going concern problems that
are present.
1161
Indicators of going concern issues would include trading losses, impairment of

assets, net liabilities, defaults on loans, liquidity problems, an inability to refinance
loans where necessary, fundamental changes in the markets or technology having an
adverse effect on the company, loss of management, staff, customers or suppliers, or
major litigation, for example.
Auditors should consider the need to obtain written management representations.
Auditors should consider the adequacy of any disclosures in the financial

statements.
(b) Possible audit reports and circumstances
Where the auditors consider that there is a significant level of concern about the
entitys ability to continue as a going concern (but do not disagree with the going
concern basis), and where adequate disclosures of the situation are made, they
modify (but do not qualify) their opinion by including an emphasis of matter
paragraph highlighting the existence of a material uncertainty as to the going
concern status of the entity and drawing attention to the relevant note in the
financial statements. Where adequate disclosures are not made, a qualified or
adverse opinion will be issued.
Where the period to which directors have paid particular attention is less than 12
months from the end of the reporting period, the auditors should consider the need
to modify the audit report as a result of a limitation in the scope of the audit.
Where the auditors disagree with the preparation of the financial statements on the
going concern basis, they should issue an adverse opinion. This is very rare because
auditors rarely have sufficient evidence to be sure.
If the auditors are unable to form an opinion on the going concern status of a
company because of a limitation in the scope of the audit, they will issue an except
for opinion, or disclaimer of opinion but this is unusual.
(c) Report issued to Corsco
In the case of Corsco, there are some indicators of going concern problems.
However, the company may still be a going concern and the fact that the company
has been approached by take-over bidders does not necessarily mean that there is a
going concern problem (possibly quite the opposite).
The audit opinion issued on Corsco in the current year is not likely to make
reference to the going concern status of the company, as in previous years. The
situation has not deteriorated significantly in the current year and it will be difficult
for auditors to justify any change in their opinion from previous years.
(d) Difficulties associated with reporting on going concern
If the auditors of Corsco were to report on a going concern problem, the mere act of
reporting might of itself create a going concern problem (a self-fulfilling
prophecy). This is particularly the case with large blue-chip companies where
the issue of an audit report that is modified in any way is unusual and might well
cause the companys share price to drop, thus precipitating a going concern
problem.
1162
This means that it is very difficult for companies such as Corsco and their auditors
to send out any clear signal to the markets without running the risk of creating a
panic.
However, recent events show that the consequences of companies and auditors
failing to report where severe financial difficulties are encountered can be disastrous
for both the company (its employees and shareholders) and auditors alike.
Auditors are failing in their professional duties if they do not report on going
concern problems of which they are aware; however, situations involving large
companies are rarely clear cut and auditors who propose to make any changes at all
to the audit report are likely to encounter fierce resistance from management who
may genuinely believe that to make such a report would be wrong.
In the companys annual financial statements, it is not the place of the auditor of
Corsco to substitute his judgement for that of directors. However, where large
companies involved in complex financing arrangements are concerned, auditors
may have to fight hard against vested and powerful interests if they disagree with
the directors judgements and decide to make reference to the matter in the auditors
report. An auditor making reference to going concern issues in an audit report in
such circumstances may lose the audit (and any other work) and may run a
significant risk of litigation.
Answer 69 OCTBALL
(a) Benefits of outsourcing to NFA
Expertise available
The NFA partnership will be able to provide the necessary expertise for internal audit work.
They may be able to provide a broader range of expertise as they serve many different clients
therefore staff may be available for specialist work that Octball could not afford to employ.
Buy-in skills as necessary
If internal audit is only required for specific functions or particular jobs each year then the
expertise can be purchased as required. Taking this approach will minimise in-house costs.
Independence/Qualifications
No information is provided on the qualification of staff in NFA, although as an independent

firm it is likely that care will be taken that staff do remain independent and have the
appropriate qualifications in order that they can provide an appropriate high level of service.
Audit techniques training
Outsourcing will remove the need for training internal staff. Effectively training will be
provided for free as the outsourcing firm will be responsible for keeping staff up-to-date
with new auditing techniques and processes.
1163
Problems with outsourcing to NFA
Fee pressure
NFA may experience some fee pressure, but only in respect of maintaining cost effectiveness
of the internal audit department. The relationship needs to be managed carefully to ensure that
NFA do not decrease the quality of their work due to insufficient fees.
Knowledge
The NFA partnership will not have any prior knowledge of Octball. This will be a
disadvantage as this will mean the partnership will need time to ascertain the accounting
systems and controls etc in Octball before commencing work. However, provision of an
independent view may identify control weaknesses etc that the current internal audit
department have missed.
Location
The NFA partnership may not be able to provide this service to Octball as they are a local
firm and therefore the issue of travel and working away from home would remain.
Continuity of service staffing
As provision of audit services is the NFA partnerships main activity, they should also be able
to budget for client requirements although this cannot be guaranteed as staff may still leave.
However, as a larger internal auditing firm, they will be able to offer staff better career
progression which should assist staff retention.
(b) Items to be considered by T&M
Independence
T&M need to ensure that independence can be maintained in a number of areas:
Independence regarding recommending systems or preparing working papers and

subsequent checking of those systems or working papers. While the internal audit
department may need to carry out these functions, T&M must ensure that separate
staff are used to provide the internal and external audit functions.
Staff from T&M will be expected to follow the ethical guidance of ACCA which
means that steps will be taken to avoid conflicts of interest or other independence
issues such as close personal relationships building up with staff in Octball. Any
real or perceived threats to independence will lower the overall trust that can be
placed on internal audit reports produced by T&M.
Training
As a firm of auditors, T&M will automatically provide training for its staff as part of the in-
house compliance with association regulations (e.g. compulsory CPD was introduced from
January 2005). T&M will need to ensure that staff providing the internal audit function to
Octball are aware of relevant guidance for internal auditors.
1164
Skills
T&M must ensure that they have staff with the necessary skills and sufficient time to
undertake the internal audit work in Octball. Skills may not be an issue because staff in T&M
will already understand audit procedures.
Fee pressure
There may be fee pressure on T&M, either to maintain the cost effectiveness of the internal
audit department, or to maintain the competitiveness of the audit fee itself in order to keep the
internal audit work.
Knowledge
As external auditors, T&M will already have knowledge of Octball. This will assist in
establishing the internal audit department as systems documentation will already be available
and the audit firm will already be aware of potential weaknesses in the control systems.
(c) Controls to maintain the standard of the internal audit department
If T&M are appointed, ensure that the internal and external audit is managed by
different departments in the firm.
Setting and review of performance measures such as cost, areas reviewed etc with
explanations obtained for any significant variances.
Use of appropriate audit methodology, including clear documentation of audit work

carried out, adequate review, and appropriate conclusions drawn.
Review of working papers by myself, ensuring adherence to International Standards

on Auditing where appropriate and any in-house standards on auditing.
The work plan for internal audit is agreed prior to work commencing and this is
followed by the outsourcing company.
Answer 70 ZPM
(a) Factors to consider when evaluating and testing the work of the internal auditor
include:
A check that the work is performed by persons having adequate technical training
and proficiency as internal auditors, by ensuring appropriate training programmes
are in place and the auditor has appropriate qualifications.
Ensuring that the work of assistants is properly supervised, reviewed and

documented by reviewing the procedure manuals of internal audit and the audit
working papers produced.
Determining that sufficient and appropriate audit evidence is obtained to afford a

reasonable basis for the conclusions reached, again by reviewing the internal
auditors working papers.
Checking that the conclusions reached are appropriate in the circumstances and that
any reports prepared are consistent with the results of the work performed by
reviewing the work performed and the reports produced.
1165
Ensuring any exceptions or unusual matters disclosed by internal audit are properly
resolved by the external auditor and management.
(b)
(i) Objectives of internal audit
Year end inventory count
The main aim of the year end inventory count is to ensure that the figure for inventory in the
financial statements is accurate. The objective of the internal audit department is to check the
accuracy of the inventory count to ensure that the physical goods inventory is correctly stated
on the inventory sheets. This objective is achieved by checking the control system over
counting inventory. Internal audit work will involve ensuring that all inventory is counted,
teams of two people are counting inventory, and then performing test counts to determine the
accuracy of the test counts.
Internal controls over procurement systems
The internal auditor will be ensuring that the procurement system is achieving its key
objectives and operating according to company guidelines. Specific aims will include:
Ensuring purchases are authorised
Quantity discounts are obtained
Inventory received is recorded on goods received notes or similar.
Reviewing operations of the marketing department
The internal auditor will review the work of the marketing department with aims such as
ensuring that the process is being managed effectively and information is available to the
marketing manager as required. Where deficiencies in the information provided are noted,
then an internal audit report will highlight those deficiencies and make recommendations for
improvement to the information systems. The objectives of internal audit in this case are more
to ensuring the efficiency of operations rather than any specific financial objective.
(ii) Objectives of the external auditor
The external auditor also needs to ensure that the figure for inventory is materially correct for
the financial statements. Part of the work of the external auditor is to attend the physical
inventory count to ensure that the quantities and condition of inventory is correctly recorded.
Given that ZPM does not appear to have any perishable inventory, the main objective will be
to ensure correct recording of inventory quantity.
The external auditor will test the procurement system with the overall objective of
determining that the purchases and payables figures in the financial statements are correct.
The objectives of testing will be to ensure that the control system over procurement is
operating efficiently, and ensure complete and accurate recording of purchases and payables
liabilities. If errors are found then this implies that the financial statements could also contain
errors.
1166
As the operations of the marketing department do not normally impact on the financial
statements, the external auditor may not actually review this function.
(iii) Reliance by the external auditor
ZPM has 103 stores which is likely to mean that the external auditor will not be able to
attend the inventory count in all stores, simply due to lack of staff. However, if inventory
count procedures are the same at all stores, then reliance can be placed on the internal auditor
to attend some stores and check that the internal control systems are being correctly applied in
those stores. This reliance does not mean that the external auditor does not carry out any
work; the external auditor will compare results from stores tested with those of the internal
auditor. Results should be about the same; any differences in terms of errors found will be
investigated, and reasons for those differences obtained.
The external auditor may rely on the work of the internal auditor regarding the procurement
systems, where the work of the internal auditor is relevant to the financial statements. Some
areas such as ensuring quantity discounts are obtained are less important than ensuring
completeness of recording of liabilities. Again, the external auditor must perform some work
on the procurement systems; the presence of an internal auditor simply means that the work
can be reduced.
Given that the external auditor does not need to review the operations of the marketing
department then no formal reliance is needed on the work of the internal auditor. However,
internal audit reports may be reviewed to determine, for example, the effectiveness of
advertising spend etc to help determine the going concern situation of the company. In the
case of ZPM, the effectiveness of advertising new stores could be reviewed.
1167
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REVISION QUESTION BANK AUDIT AND ASSURANCE (Int) (F8)

Answer 1 AUDITORS AND AUDITING STANDARDS

(a) Development, role, and authority of ISAs

International Standards on Auditing are set by the International Auditing and

Project is proposed and input sought

If approved, project assigned to a Task Force

Research carried out and Exposure Draft prepared

ED placed on IFAC website and widely distributed for comment

Comments received are considered, ED revised and re-issued if

Revised ED approved and issued as a Standard

The Consultancy Advisory Group gives representatives of the business community

In exceptional circumstances, a professional accountant may judge it necessary to

(b) The role of the ACCA in the regulation of auditors

Auditors are regulated differently in different countries. In some countries

setting, monitoring and enforcing accounting and auditing standards

Professional bodies such as the ACCA, seek to uphold professional standards, to

The ACCA encourages high professional standards by setting academic

(c) How ISAs and national standards influence each other

In a global market-place it is increasingly important that Auditing Standards are

Standard setters in countries where the profession is mature make a significant

Answer 2 JUMPER & CO

From: A Manager, Tela & Co

I recommend that an appointments committee is established comprising three non-executive directors to

I recommend that a remuneration committee is established comprising three non-executive directors.

Answer 3 CORPORATE GOVERNANCE

From: Chief Internal Auditor

Application of ISA and IFRS

Communication with external auditors

Under corporate governance regulations, communications with external auditors will

Communication to the board

(b) The advantages of an audit committee include:

Providing increasing public confidence in the creditability and objectivity of published

Enhancing the role of ZXs external auditors by providing an appropriate channel of

Friend of the Board

The disadvantages of an audit committee include:

Lack of understanding of function

Role of non-executive directors

Answer 4 FRAUD AND COMPLIANCE SEMINAR

(a) Missing share certificates

(b) Product safety

(c) Understatement of royalties

(d) Unclaimed wages

If there is no immediately apparent explanation, such as an employee on long-term sick leave,

Answer 5 STONE HOLIDAYS

(a) Internal audit function: risk of fraud and error

(1) commenting on the process used by management to identify and classify

(2) commenting on the appropriateness and effectiveness of actions taken by

(3) periodically auditing or reviewing systems or operations to determine

(b) External auditors: fraud and error in an audit of financial statements

Auditors should make enquiries of management regarding managements

Auditors should consider fraud risk factors, unusual or unexpected relationships,

Auditors should determine an overall response to the assessed risk of material

It is accepted that because of the hidden nature of fraud, an audit properly

(a) Removal from office

(i) Removal by management

The financial statements being reported on represent a statement of accountability by

Adhering strictly to professional independence rules to ensure an ability to

Adhering to professional rules relating to providing advice to non-audit clients,

(ii) Audit committee

(i) Rules of Professional Conduct

An auditor should not provide accountancy services to listed or public interest

Nevertheless, it illustrates concerns that would arise in the minds of users of